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SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 
 FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934FOR THE QUARTERLY PERIOD ENDED March 31, 2005ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934FOR THE TRANSITION PERIOD FROM TO .
 Commission File Number: 000-24647 TERAYON COMMUNICATION SYSTEMS, INC.  DELAWARE
(STATE OR OTHER JURISDICTION OF
INCORPORATION OR ORGANIZATION)
    
    77-0328533
(IRS EMPLOYER
IDENTIFICATION NO.)
 4988 GREAT AMERICA PARKWAY
SANTA CLARA, CALIFORNIA 95054
(408) 235-5500 
   Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ     No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). Yes þ     No o APPLICABLE ONLY TO CORPORATE ISSUERS: As of April 15, 2005 registrant had outstanding 76,869,633 shares of Common Stock.




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INDEX TERAYON COMMUNICATION SYSTEMS, INC. Page No.PART I FINANCIAL INFORMATIONItem 1.
    
    FINANCIAL STATEMENTS
    
    
    3Item 2.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    16Item 3.
    
    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    45Item 4.
    
    CONTROLS AND PROCEDURES
    
    
    45PART II OTHER INFORMATIONItem 1.
    
    LEGAL PROCEEDINGS
    
    
    47Item 6.
    
    EXHIBITS
    
    
    48EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
 2




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PART I. FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS TERAYON COMMUNICATION SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands) March 31,
    
    
    December 31,2005
    
    
    2004(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    30,637
    
    
    $
    43,218Short-term investments
    
    
    69,180
    
    
    
    54,517Accounts receivable, net
    
    
    13,380
    
    
    
    16,554Accounts receivable from related parties
    
    
    6,356
    
    
    
    3,106Other current receivables
    
    
    1,242
    
    
    
    1,044Inventory
    
    
    18,611
    
    
    
    17,144Other
current assets
    
    
    1,634
    
    
    
    2,042Total current assets
    
    
    141,040
    
    
    
    137,625Property and equipment, net
    
    
    4,840
    
    
    
    5,760Restricted cash
    
    
    8,817
    
    
    
    8,827Other assets, net
    
    
    710
    
    
    
    1,522Total assets
    
    $
    155,407
    
    
    $
    153,734LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    8,278
    
    
    $
    7,845Accrued payroll and related expenses
    
    
    3,601
    
    
    
    3,936Deferred revenues
    
    
    2,862
    
    
    
    2,579Deferred
gain on sale of  semiconductor assets
    
    
    6,210
    
    
    
    Accrued warranty expenses
    
    
    3,141
    
    
    
    3,870Current
portion of accrued restructuring and executive severance
    
    
    3,092
    
    
    
    3,902Accrued vendor cancellation charges
    
    
    373
    
    
    
    521Accrued other liabilities
    
    
    4,031
    
    
    
    4,562Interest payable
    
    
    542
    
    
    
    1,356Total current liabilities
    
    
    32,130
    
    
    
    28,571Other long-term obligations
    
    
    1,725
    
    
    
    2,077Long term
portion of accrued restructuring and executive severance
    
    
    1,772
    
    
    
    1,664Convertible subordinated notes
    
    
    65,081
    
    
    
    65,081Commitments and contingenciesStockholders equity:Common stock
    
    
    77
    
    
    
    76Additional paid in capital
    
    
    1,085,008
    
    
    
    1,083,711Accumulated deficit
    
    
    (1,026,695
    )
    
    
    (1,024,091
    )Treasury stock, at cost
    
    
    (773

    )
    
    
    (773
    )Accumulated other comprehensive loss
    
    
    (2,918
    )
    
    
    (2,582
    )Total stockholders equity
    
    
    54,699
    
    
    
    56,341Total liabilities and stockholders equity
    
    $
    155,407
    
    
    $
    153,734
 See accompanying notes. 3




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TERAYON COMMUNICATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited) Three Months EndedMarch 31,2005
    
    
    2004Revenues
    
    $
    17,536
    
    
    $
    40,423Related party revenues
    
    
    8,827
    
    
    
    745Total revenues
    
    
    26,363
    
    
    
    41,168Cost of revenues
    
    
    11,360
    
    
    
    28,564Cost of related party revenues
    
    
    1,683
    
    
    
    207Total cost of revenues
    
    
    13,043
    
    
    
    28,771Gross profit
    
    
    13,320
    
    
    
    12,397Operating expenses:Research and development
    
    
    5,944
    
    
    
    9,467Sales and marketing
    
    
    5,673
    
    
    
    7,221General and administrative
    
    
    2,795
    
    
    
    2,436Restructuring charges, executive severance and asset write-offs
    
    
    1,282
    
    
    
    3,367Total operating expenses
    
    
    15,694
    
    
    
    22,491Loss from operations
    
    
    (2,374
    )
    
    
    (10,094
    )Interest income
    
    
    568
    
    
    
    452Interest expense
    
    
    (814
    )
    
    
    (819
    )Other income
    
    
    66
    
    
    
    280Loss before income tax expense
    
    
    (2,554
    )
    
    
    (10,181
    )Income tax expense
    
    
    (50
    )
    
    
    (66
    )Net loss
    
    $
    (2,604
    )
    
    $
    (10,247
    )Net loss per share, basic and diluted
    
    $
    (0.03
    )
    
    $
    (0.14
    )Shares used in per share calculation, basic and diluted
    
    
    76,738
    
    
    
    75,516
 See accompanying notes. 4




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TERAYON COMMUNICATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited) Three Months EndedMarch 31,2005
    
    
    2004Operating activities:Net loss
    
    $
    (2,604
    )
    
    $
    (10,247
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    853
    
    
    
    1,842Reduction of accounts receivable allowance
    
    
    (675
    )
    
    
    Amortization of deferred compensation
    
    
    
    
    
    
    17Inventory reserves
    
    
    373
    
    
    
    623Impairment
and write-off of fixed assets
    
    
    272
    
    
    
    124Net changes in operating assets and liabilities:Accounts receivable
    
    
    3,849
    
    
    
    385Accounts receivable from related parties
    
    
    (3,250
    )
    
    
    373Inventory
    
    
    (1,840
    )
    
    
    (3,526
    )Other assets
    
    
    1,032
    
    
    
    2,334Accounts payable
    
    
    433
    
    
    
    (4,687
    )Accrued payroll and related expenses
    
    
    (335
    )
    
    
    (1,465
    )Deferred revenues
    
    
    283
    
    
    
    1,028Accrued warranty expenses
    
    
    (729
    )
    
    
    (904
    )Accrued
restructuring and executive severance
    
    
    (702
    )
    
    
    2,098Accrued vendor cancellation charges
    
    
    (148
    )
    
    
    (1,470
    )Other accrued liabilities
    
    
    (2,202
    )
    
    
    (1,655
    )Interest payable
    
    
    (814
    )
    
    
    Net cash used in operating activities
    
    
    (6,204
    )
    
    
    (15,130
    )Investing activities:Purchases of short-term investments
    
    
    (27,176
    )
    
    
    (39,997
    )Proceeds from sales and maturities of short-term investments
    
    
    12,208
    
    
    
    101,301Proceeds
from sale of semiconductor assets, net
    
    
    7,892
    
    
    
    Purchases of property and equipment
    
    
    (568
    )
    
    
    (916
    )Net cash provided by (used in) investing activities
    
    
    (7,644
    )
    
    
    60,388Financing activities:Principal payments on capital leases
    
    
    
    
    
    
    (50
    )Proceeds from issuance of common stock
    
    
    1,298
    
    
    
    740Net cash provided by financing activities
    
    
    1,298
    
    
    
    690Effect of foreign currency exchange rate changes
    
    
    (31
    )
    
    
    (76
    )Net increase (decrease) in cash and cash equivalents
    
    
    (12,581
    )
    
    
    45,872Cash and cash equivalents at beginning of period
    

    
    43,218
    
    
    
    30,188Cash and cash equivalents at end of period
    
    $
    30,637
    
    
    $
    76,060
 See accompanying notes. 5




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TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) 1. Organization Description of Business Terayon Communication Systems, Inc. (Company) was incorporated under the laws of the State of
California on January 20, 1993. In June 1998, the Company reincorporated in the State of Delaware. The Company develops, markets and sells equipment to broadband service providers who use the
Companys products to deliver broadband voice, digital video solutions (DVS) and data services to
residential and business subscribers. 2. Summary of Significant Accounting Policies Basis of Presentation The
accompanying condensed consolidated financial statements have been
prepared in accordance with U.S. generally accepted accounting principles for interim financial
information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes
required by U.S. generally
accepted accounting principles for complete financial statements. In the
opinion of management, all adjustments (consisting of normal recurring adjustments) necessary for a
fair presentation of the condensed consolidated financial statements at March 31, 2005 and for the three months ended
March 31, 2005 and 2004 have been included. Results for the three months ended March 31, 2005 are not necessarily indicative of results
for the entire fiscal year or future periods. These financial statements should be read in
conjunction with the consolidated financial statements and the accompanying notes included in the
Companys Form 10-K dated March 15, 2005, as filed with the U.S. Securities and Exchange
Commission. The accompanying condensed consolidated balance sheet at December 31, 2004 is derived from audited
consolidated financial statements at that date. Basis of Consolidation The condensed consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries. All inter-company balances and transactions have been eliminated. Use of Estimates The
preparation of the condensed consolidated financial statements in
conformity with U.S.
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates. Estimates are based on historical
experience, input from sources outside of the Company, and other relevant facts and circumstances.
Areas that are particularly significant include the Companys valuation of its accounts receivable
and inventory, the assessment of recoverability and the measurement of impairment of fixed
assets, and the recognition of restructuring liabilities. Stock-based compensation The Company accounts for stock-based compensation for its employees using the intrinsic value
method presented in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock
Issued to Employees, (APB 25), and includes the disclosure-only provisions as required under
Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based
Compensation (SFAS 6




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123). The Company provides additional pro forma disclosures as required under SFAS 123 and
SFAS 148, Accounting for Stock-Based Compensation, Transition and Disclosure. For purposes of pro forma disclosures, the estimated fair value of the options granted and
employee stock purchase plan shares to be issued is amortized to expense over their respective
vesting periods. Had compensation cost for the Companys stock-based compensation plans been
determined based on the fair value at the grant dates for awards under those plans consistent with
the method of SFAS 123, the Companys net loss and net loss per
share would have been increased to the pro forma amounts
indicated below (in thousands, except per share data): For the three months endedMarch 31,2005
    
    
    2004Net loss, as reported
    
    $
    (2,604
    )
    
    $
    (10,247
    )Add:      Stock-based compensation under APB 25
    
    
    
    
    
    
    17Deduct: Stock option compensation expense
determined under fair value-based method
    
    
    (1,316
    )
    
    
    (4,509
    )Employee stock purchase plan
compensation expense determined
under fair value-based method
    
    
    
    
    
    
    (357
    )Pro forma net loss
    
    $
    (3,920
    )
    
    $
    (15,096
    )Net loss per
share, basic and diluted, as reported
    
    $
    (0.03
    )
    
    $
    (0.14
    )Pro forma net loss per share, basic and diluted
    
    ($
    0.05
    )
    
    $
    (0.20
    )Shares used
in computing pro forma net loss per share,
basic and diluted
    
    
    76,738
    
    
    
    75,516
 Inventory Inventory is stated at the lower of cost (first-in, first-out) or market. The components of
inventory are as follows (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Raw materials
    
    $
    2,107
    
    
    $
    1,880Work-in-process
    
    
    0
    
    
    
    1,501Finished goods
    
    
    16,504
    
    
    
    13,763Inventory, net
    
    $
    18,611
    
    
    $
    17,144
 Purchase Obligations The Company has purchase obligations to certain of its suppliers that support the Companys
ability to manufacture its products. The obligations consist of purchase orders placed with
vendors for goods and services and require the Company to purchase minimum quantities of the
suppliers products at a specified price. As of March 31, 2005, $24.1 million of purchase
obligations were outstanding. The Company accrued for vendor
cancellation charges in an amount, which
represented managements estimate of the Companys exposure to vendors for its inventory
commitments. At March 31, 2005, accrued vendor cancellation charges were $0.4 million and the
remaining $23.7 million was attributable to open purchase orders in the normal course of business.
The remaining obligations are expected to become payable at various times throughout 2005. 7




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Changes in Accounting Estimates For the three months ended March 31, 2005 and March 31, 2004, the Companys gross margins were
benefited by the reversal of approximately $0.2 million and $1.3 million, respectively of accrued
vendor cancellation charges, which were previously recorded as cost of
revenues. Additionally, during the
three months ended March 31, 2005 and March 31, 2004, the Companys gross margins were benefited by
the sale of inventory of approximately $0.5 million and $0.7 million,
respectively, originally considered to be excess or obsolete, which
had been written off in prior periods. In
the  first quarter of 2005, the Company reversed approximately $0.6
million of accounts receivable reserve as the Company was able to
collect accounts which had previously been specifically reserved. Net Loss Per Share A reconciliation of the numerator and denominator of basic and diluted net loss per share is
provided as follows (in thousands, except per share amounts): For the three months endedMarch 31,2005
    
    
    2004Net loss
    
    $
    (2,604
    )
    
    $
    (10,247
    )Shares used in computing basic and
diluted net loss per share
    
    
    76,738
    
    
    
    75,516Basic and diluted net loss per share
    
    $
    (0.03
    )
    
    $
    (0.14
    )
 Options to purchase 14,019,701 and 16,527,067 shares of common stock were outstanding at March
31, 2005 and March 31, 2004, respectively, but were not included in the computation of diluted net
loss per share since the effect would have been anti-dilutive. Accumulated Other Comprehensive Loss Accumulated other comprehensive loss presented in the accompanying condensed consolidated
balance sheets consists of net unrealized gains or losses on short-term investments and accumulated
net foreign currency translation gains or losses. The following are the components of comprehensive loss (in thousands): For the three months endedMarch 31,2005
    
    
    2004Net loss
    
    $
    (2,604
    )
    
    $
    (10,247
    )Cumulative translation adjustments.
    
    
    (31
    )
    
    
    (76
    )Change in unrealized gain (loss) on available-
for-sale investments
    
    
    (305
    )
    
    
    3Total comprehensive net loss
    
    $
    (2,940
    )
    
    $
    (10,320
    )
 Impact of Recently Issued Accounting Standards On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123
(revised 2004), (SFAS 123(R)), Share-Based Payment, which replaces SFAS 123, Accounting
for Stock-Based Compensation, and supersedes APB 25, Accounting for Stock Issued to
Employees. Generally, the approach in SFAS 123(R) is similar
to the approach described in SFAS 123. SFAS 123(R) eliminates the alternative to use APB 25s intrinsic value method of
accounting that was provided in SFAS 123 as originally issued. After
a phase-in period for SFAS 123(R), pro forma disclosure will no longer be allowed. The SEC announced in the second quarter
of 2005
that it would extend this phase-in period and, therefore, the Companys effective date for
implementation of SFAS 123(R) is January 1, 2006. The Company has not yet determined which phase-in
method it will adopt. 8




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In the first quarter of 2005 the Securities and Exchange Commission (SEC)
issued Staff Accounting Bulletin No. 107 which provided further clarification on the implementation
of SFAS 123(R). As permitted by SFAS 123, the Company currently accounts for share-based payments to
employees using APB 25s intrinsic value method and, as such, generally recognizes no
compensation expense for employee stock options. Accordingly, the
adoption of SFAS 123(R)s fair
value method will likely have a material impact on the Companys results of operations, although it will have
no impact on its overall financial position. See Stock Based Compensation, above for information
related to the pro forma effects on the Companys reported net loss and net loss per common share
of applying the fair value recognition provisions of the previous
SFAS 123 to stock-based
employee compensation. In
November 2004, the FASB issued SFAS 151, Inventory Costs,
which revised Accounting Research Bulletin No. 43 (ARB 43), relating to inventory costs. This revision is to clarify
the accounting for abnormal amounts of idle facility expense,
freight, handling costs and wasted material (spoilage). SFAS 151
requires that these items be recognized as a current period charge
regardless of whether they meet the criterion specified in ARB 43. In
addition, SFAS 151 requires the allocation of fixed production
overheads to the costs of conversion be based on normal capacity of
the production facilities. SFAS 151 is effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. The
Company does not believe the adoption of SFAS 151 will have a
material impact on the Companys financial statements. 3. Contingencies Beginning in April 2000, several plaintiffs filed class action lawsuits in federal court
against the Company and certain of the Companys officers and directors. Later that year, the cases
were consolidated in the United States District Court, Northern District of California as In re
Terayon Communication Systems, Inc. Securities Litigation. The Court then appointed lead plaintiffs
who filed an amended complaint. In 2001, the Court granted in part and denied in part defendants
motion to dismiss, and plaintiffs filed a new complaint. In 2002, the Court denied defendants
motion to dismiss that complaint, which, like the earlier complaints, alleges that the defendants
violated the federal securities laws by issuing materially false and misleading statements and
failing to disclose material information regarding the Companys technology. On February 24, 2003,
the Court certified a plaintiff class consisting of those who purchased or otherwise acquired the
Companys securities between November 15, 1999 and April 11, 2000. On September 8, 2003, the Court heard defendants motion to disqualify two of the lead
plaintiffs and to modify the definition of the plaintiff class. On September 10, 2003, the Court
issued an order vacating the hearing date for the parties summary judgment motions, and, on
September 22, 2003, the Court issued another order staying all discovery until further notice and
vacating the trial date, which had been November 4, 2003. On February 23, 2004, the Court issued an order disqualifying two of the lead plaintiffs. The
order also states that plaintiffs counsel must provide certain information to the Court about
counsels relationship with the disqualified lead plaintiffs, and it provides that defendants may
serve certain additional discovery. On March 24, 2004, plaintiffs submitted certain documents to
the Court in response to its order, and, on April 16, 2004, the Company responded to this
submission. The Company has also initiated discovery pursuant to the Courts February 23, 2004
order. Were an unfavorable ruling to occur in this legal matter,
there exists the possibility of a material adverse impact on the
Companys results of operations for the period in which the
ruling occurs. On October 16, 2000, a lawsuit was filed against the Company and the individual defendants
(Zaki Rakib, Selim Rakib and Raymond Fritz) in the California Superior Court, San Luis Obispo
County. This lawsuit is titled Bertram v. Terayon Communications Systems, Inc. The factual
allegations in the Bertram complaint were similar to those in the federal class action, but the
Bertram complaint sought remedies under state law. Defendants removed the Bertram case to the
United States District Court, Central District of California, which dismissed the complaint and
transferred the case to the United States District Court, Northern District of California. That
Court eventually issued an order dismissing the case. Plaintiffs have appealed this order, and
their appeal was heard on April 16, 2004. On June 9, 2004, the United States Court of Appeals for
the Ninth Circuit affirmed the order dismissing the Bertram case. The Court of Appeals opinion affirming dismissal of the Bertram case does not end the class
action. The Company believes that the allegations in the class action are without merit, and
intends to contest this matter vigorously. This matter, however, could prove costly and time
consuming to defend, and there can be no assurances about the eventual outcome. In 2002, two shareholders filed derivative cases purportedly on behalf of the Company against
certain of its current and former directors, officers, and investors. (The defendants differed
somewhat in the
two cases.) Since the cases were filed, the investor defendants have been dismissed without
prejudice, and the lawsuits have been consolidated as Campbell v. Rakib in the California Superior
Court, Santa Clara 9




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County. The Company is a nominal defendant in these lawsuits, which allege
claims relating to essentially the same purportedly misleading statements that are at issue in the
pending securities class action. In the securities class action, the Company disputes making any
misleading statements. The derivative complaints also allege claims relating to stock sales by
certain of the director and officer defendants. The Company believes that there are many defects in the Campbell and OBrien derivative
complaints.
However, were an unfavorable ruling to occur in this legal matter,
there exists the possibility of a material adverse impact on the
Companys results of operations for the period in which the
ruling occurs. In January 2005, Adelphia Corporation (Adelphia) sued the Company in the District Court of the
City and County of Denver, Colorado. Adelphias complaint alleges, among other things, breach of
contract and misrepresentation in connection with the Companys sale of CMTS products to Adelphia
and the Companys announcement to cease future investment in the CMTS market. Adelphia seeks
unspecified monetary damages and declaratory relief. The Company filed a motion to dismiss the
complaint on February 24, 2005. On March 21, 2005, Adelphia filed its response to the motion to
dismiss the complaint, and on April 5, 2005, the Company filed its reply in support of the motion
to dismiss the complaint. On April 29, 2005, the court denied the Companys motion to dismiss
the complaint, thereby permitting the case and discovery to go forward. The Company has until May 19, 2005 to respond to
Adelphias complaint. As the Company believes that Adelphias allegations are without merit, it
intends to contest this matter vigorously. This matter, however, could prove costly and time
consuming to defend, and there can be no assurances about the eventual outcome.
Were an unfavorable ruling to occur in this legal matter, there
exists the possibility of a material adverse impact on the
Companys results of operations for the period in which the
ruling occurs. The Company has received letters claiming that its technology infringes the intellectual
property rights of others. The Company has consulted with its patent counsel and is in the process
of reviewing the allegations made by such third parties. If these allegations were submitted to a
court, the court could find that the Companys products infringe third party intellectual property
rights. If the Company is found to have infringed third party rights, the Company could be subject
to substantial damages and/or an injunction preventing the Company from conducting its business. In
addition, other third parties may assert infringement claims against the Company in the future. A
claim of infringement, whether meritorious or not, could be time-consuming, result in costly
litigation, divert the Companys managements resources cause product shipment delays or require
the Company to enter into royalty or licensing arrangements. These royalty or licensing
arrangements may not be available on terms acceptable to the Company, if at all. Furthermore, the Company has in the past agreed to, and may from time to time in the future
agree to, indemnify a customer of its technology or products for claims against the customer by a
third party based on claims that its technology or products infringe intellectual property rights
of that third party. These types of claims, meritorious or not, can result in costly and
time-consuming litigation; divert managements attention and other resources; require the Company
to enter into royalty arrangements; subject the Company to damages or injunctions restricting the
sale of its products; require the Company to indemnify its customers for the use of the allegedly
infringing products; require the Company to refund payment of allegedly infringing products to its
customers or to forgo future payments; require the Company to redesign certain of its products; or
damage its reputation, any one of which could materially and adversely affect the Companys
business, results of operations and financial condition. The Company may, in the future, take legal action to enforce its patents and other
intellectual property rights, to protect its trade secrets, to determine the validity and scope of
the proprietary rights of others, or to defend against claims of infringement or invalidity. Such
litigation could result in substantial costs and diversion of resources and could negatively affect
the Companys business, operating results, financial position and liquidity. The Company is currently a party to various other legal proceedings, in addition to those
noted above, and may become involved from time to time in other legal proceedings in the future.
While the Company currently believes that the ultimate outcome of these proceedings,
individually and in the aggregate, will not have a material adverse effect on its financial
position or overall results of operations, litigation is subject to inherent uncertainties. Were an
unfavorable ruling to occur in any of the Companys legal proceedings, there exists the possibility
of a material adverse impact on the Companys results of operations for the period in which the
ruling occurs. The estimate of the potential impact on the Companys financial position and overall
results of operations for any of the above legal proceedings could change in the future. 10




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##### Table of Contents



Table of Contents 4. Operating Segment Information The Company operates as one business segment. Three months endedMarch 31,(in thousands)
    
    2005
    
    
    2004Revenues by product:Digital Video Solutions (DVS)
    
    $
    13,046
    
    
    $
    6,071Home Access Solutions (HAS)
    
    
    11,569
    
    
    
    23,776Cable Modem Termination Systems (CMTS)
    
    
    1,652
    
    
    
    11,135Other
    
    
    96
    
    
    
    186Total revenues
    
    $
    26,363
    
    
    $
    41,168Revenues by geographic areas:United States
    
    $
    15,267
    
    
    $
    21,832Americas excluding, United States
    
    
    137
    
    
    
    1,639Europe, Middle East and Africa, (EMEA),
excluding Israel
    
    
    4,186
    
    
    
    7,924Israel
    
    
    1,187
    
    
    
    3,284Asia excluding Japan
    
    
    5,565
    
    
    
    4,095Japan
    
    
    
    
    
    
    2,394Other
    
    
    21
    
    
    
    Total
    
    $
    26,363
    
    
    $
    41,168
 March 31,
    
    
    December 31,2005
    
    
    2004Long-lived assets:United States
    
    $
    4,255
    
    
    $
    4,423Americas excluding United States
    
    
    
    
    
    
    402EMEA excluding Israel
    
    
    115
    
    
    
    131Israel
    
    
    367
    
    
    
    687Asia
    
    
    103
    
    
    
    117Total long-lived assets
    
    
    4,840
    
    
    
    5,760Total current assets
    
    
    141,040
    
    
    
    137,625Other assets
    
    
    9,527
    
    
    
    10,349Total assets
    
    $
    155,407
    
    
    $
    153,734
 One
customer, Harmonic, which is a related party (See Note 6) accounted for 10% or more of total revenues (33%) for the three months
ended March 31, 2005. One customer, Adelphia accounted for 10% of total revenues (24%) for the
three months ended March 31, 2004. No other customer accounted for more than 10% of revenues
during these periods. Additionally, one customer accounted for more
than 10% of the Companys accounts receivables (32%) at
March 31, 2005. 5. Restructuring Charges and Asset Write-offs Restructuring The Company accrues for termination costs in accordance with paragraph 3 of
SFAS 146 Accounting for Costs Associated with Exit or Disposal
Activities,  and SFAS 112, Employers Accounting for Post Employment Benefits.
Liabilities are initially measured at their fair value on the date in which they are incurred based
on plans approved by the Companys Board of Directors. Accrued employee termination costs
principally consist of three components: 1) a lump-sum severance payment based upon the years of
service (e.g. two weeks per year of service); 2) COBRA insurance based on years of service and
rounded up to the month; and 3) an estimate of costs for outplacement services immediately provided to the affected employees.
Most employees are terminated on the date of notification so there is no additional service period
required to be 11




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##### Table of Contents



included in the determination of accrued termination costs. Where such services are
required for a period over 60 days the Company ratably amortizes
termination costs over the required
service period. 2004 Restructurings During the first quarter of 2004, the Company initiated a Board of Directors approved
restructuring plan to bring operating expenses in line with revenue levels. The Company incurred
restructuring charges in the amount of $3.3 million of which $1.0 million related to employee
termination costs, $0.9 million related to termination costs for an aircraft lease, and $1.4
million related to costs for excess leased facilities in the first
quarter of 2004. The Company incurred additional
restructuring charges in the amount of $1.1 million in the second quarter of 2004 related to
additional costs for excess leased facilities resulting in a second restructuring plan. In the
fourth quarter of 2004 to further conform the Companys expenses to its revenue and to cease
investment in the CMTS product line, the Companys Board of Directors approved a third
restructuring plan that resulted in a charge in the amount of $1.3 million related to employee
terminations. During the first quarter of 2005, the Company recorded
an additional charge of $0.6 million of 2004
employee termination costs related to the CMTS product line. Each quarter, the Company re-evaluates the 2004 restructuring charges for the employee
severance, excess leased facilities and the aircraft lease. Based on market conditions, new
assumptions provided by its real-estate broker, and the terms of an aircraft sublease agreement,
which the Company entered into in the third quarter of 2004, the Company revalues the restructuring
liability. During the first quarter of 2005 the Company re-evaluated
the 2004 restructuring liability estimates.
Based on new assumptions provided by its real-estate broker,
the Company increased the 2004 restructuring accrual by $0.7 million for the quarter ended March
31, 2005. As
of March 31, 2005, $3.7 million of 2004 restructuring charges
remained accrued. The Company had paid
$0.6 million in termination costs, $0.1 million of costs
related to the aircraft lease, and $0.3
million of costs related to excess leased facilities in the three
months ended March 31, 2005. The Company anticipates the remaining restructuring accrual related to the aircraft lease to
be substantially utilized for servicing operating lease payments, through January 2007, and the
remaining restructuring accrual related to excess leased facilities to be utilized for servicing
operating lease payments or negotiating a buyout of operating lease commitments through October
2009. The
accrual for the aircraft lease approximates the difference between the Companys current
costs for the aircraft lease and the estimated income derived from the sublease of the aircraft. The amount of net charges accrued under the 2004 restructuring plans assumes that the Company
will successfully sublease excess leased facilities. The accrual for the excess leased facilities
includes the estimated income derived from subleasing, which is based on information from the
Companys real-estate brokers, who provide estimates based on assumptions relevant to the real
estate market conditions. Even though it is the Companys intent to sublease its interests in the
excess facility at the earliest possible time, the Company cannot determine with certainty a fixed
date by which such events will occur, if at all. In light of this uncertainty, the Company will
continue to periodically re-evaluate and adjust the accrual, as necessary. 12




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##### Table of Contents



This table summarizes the accrued restructuring balances related to the 2004 restructurings as
of March 31, 2005 (in thousands): ExcessLeasedFacilitiesInvoluntary
    
    
    Aircraft
    
    
    andEmployee

    
    
    Lease
    
    
    CancelledTerminations
    
    
    Termination
    
    
    Contracts,
    
    
    TotalBalance at December 31, 2004
    
    $
    592
    
    
    $
    692
    
    
    $
    1,998
    
    
    $
    3,282Cash payments
    
    
    (569
    )
    
    
    (85
    )
    
    
    (318
    )
    
    
    (972
    )Charges
    
    
    717
    
    
    
    
    
    
    
    
    
    
    
    717Changes in estimate
    
    
    
    
    
    
    
    
    
    
    659
    
    
    
    659Balance at March 31, 2005
    
    $
    740
    
    
    $
    607
    
    
    $
    2,339
    
    
    $
    3,686
 2002 Restructuring During 2002, a restructuring plan (2002 Plan)
was approved by the Board of Directors and the
Company incurred restructuring charges in the amount of $3.6 million of which $15,000 remained
accrued at March 31, 2005, for excess leased facilities in Israel. During 2004, improving real
estate market conditions in Israel gave rise to the Companys improved tenant sublease assumptions
and , as a result, the Company revalued the accrual for excess leased facilities in Israel and
decreased the accrual by $0.1 million. Additionally, the Company reclassified $1.1 million between
the 2002 Plan and 2001 Plan in the fourth
quarter of 2004. This table summarizes the accrued restructuring balances related to the 2002 Plan as of March
31, 2005 (in thousands): Excess LeasedInvoluntary
    
    
    Facilities andEmployee
    
    
    CancelledTerminations
    
    
    Contracts
    
    
    TotalBalance at December 31, 2004
    
    $
    
    
    
    $
    15
    
    
    $
    15Cash payments
    
    
    
    
    
    
    
    
    
    
    Balance at March 31, 2005
    
    $
    
    
    
    $
    15
    
    
    $
    15
 2001 Restructuring During 2001, the Board of Directors approved
a restructuring plan (2001 Plan) and the Company
incurred restructuring charges in the amount of $12.7 million of
which $1.1 million remained
accrued at March 31, 2005, for excess leased facilities in Israel. During 2004, improving real
estate market conditions in Israel gave rise to the Companys improved tenant sublease assumptions
thereby creating a change in estimate of $1.4 million. Additionally, a reclassification between the
2002 Plan and 2001 Plans increased the 2001 Plan by $1.1 million
in the fourth quarter of 2004. The Company currently
anticipates the remaining restructuring accrual relating to excess leased facilities, will be
utilized for servicing operating lease payments through 2005. During the first quarter of 2005 the Company re-evaluated the 2001
 restructuring accrual estimates for
the excess facilities in Israel. Based on actual usage and new assumptions provided by its real-estate
broker, and new assumptions for employee severance, the Company decreased the restructuring charge by $0.2 million for the quarter ended March
31, 2005. 13




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##### Table of Contents



This table summarizes the accrued restructuring balances related to the 2001 Plan as of March
31, 2005 (in thousands): ExcessLeasedInvoluntary
    
    
    Facilities andEmployee
    
    
    CancelledTerminations
    
    
    Contracts
    
    
    TotalBalance at December 31, 2004
    
    $
    50
    
    
    $
    1,788
    
    
    $
    1,838Cash payments
    
    
    (50
    )
    
    
    (460
    )
    
    
    (510
    )Changes in estimate
    
    
    
    
    
    
    (194
    )
    
    
    (194
    )Balance at March 31, 2005
    
    $
    
    
    
    $
    1,134
    
    
    $
    1,134
 Executive Severance In
2004, the Company entered into employment agreements with three
executive officers who subsequently resigned from the Company. Most
of the severance costs related to these officers were paid in 2004.
Approximately $29,000 of employee benefits for the executive officers
remain accrued, which are expected to be paid through 2005. Asset Write-offs The
Company wrote off $0.1 million in each of the three months ended March 31, 2005 and March 31, 2004, of fixed assets relating to
restructuring activities, which were determined to have no remaining useful
life. Additionally, for the three months ended March 31, 2005, the
Company wrote off $0.2 million of fixed assets, which were charged to
other income (loss). The Company did not write off any additional
assets in the three months ended March 31, 2004. 6. Related Party Transactions Lewis Solomon, a member of the Companys Board of Directors is also a member of the Board of
Directors of Harmonic, Inc. (Harmonic). Harmonic is an authorized, non-exclusive reseller of
certain of the Companys video products. For the three months ended March 31, 2005 and March 31,
2004, related party revenue from Harmonic was $8.8 million and $0.7 million, respectively. Cost of related party revenues in the Companys consolidated statements of operations consists
of direct and indirect costs. Accounts receivable from Harmonic totaled approximately $6.4 million
at March 31, 2005. Harmonic is not a supplier to the Company. 7. Product Warranties The Company provides for estimated product warranty expenses when it sells the related
products. The Company has comprehensive processes that it uses to estimate accruals for warranty
exposure. The processes include specific evaluation by product type, estimated failure rates and
costs to repair or replace. Although the Company believes it has the continued ability to
reasonably estimate warranty expenses, unforeseeable changes in factors used to estimate the
accrual for warranty could occur. These unforeseeable changes could cause a material change in the
Companys warranty accrual estimate. Such a change would be recorded in the period in which the
change was identified. An analysis of changes in the liability for product warranties for the three months ended
March 31, 2005 and 2004, is as follows (in thousands): Charges forBalance at
    
    
    Additions
    
    
    Expiration
    
    
    warranty
    
    
    Balance atbeginning of
    
    
    charged to
    
    
    accrued of
    
    
    services
    
    
    end ofperiod
    
    
    expenses
    
    
    warranty
    
    
    provided
    
    
    periodQuarter ended March
31, 2004 accrued
warranty expenses
    
    $
    5,509
    
    
    
    1,076
    
    
    
    (835
    )
    
    
    (1,145
    )
    
    $
    4,605Quarter ended March
31, 2005 accrued
warranty expenses
    
    $
    3,870
    
    
    
    286
    
    
    
    (839
    )
    
    
    (176
    )
    
    $
    3,141
 8. Sale of Certain Assets On February 7, 2005, the Company entered into an agreement with ATI Technologies, Inc (ATI) to
sell certain cable modem semiconductor assets to ATI for a total purchase price of up to $13.8
million if the Company achieves all the milestones specified in the agreement. Under the terms of
the agreement, ATI 14




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##### Table of Contents



acquired the Companys cable modem silicon intellectual property and related
software, assumed a lease and hired approximately twenty-five employees from the Companys design
team. Upon closing on March 9, 2005, the Company received $8.6 million in cash which was comprised
of a $6.95 million initial payment and $1.65 million of the $1.9 million for having met the first
milestone. ATI retained $0.25 million of the first milestone payment to pay for retention bonuses
to former Company employees that accepted employment with ATI. As of
March 31, 2005, the Company had deferred the net gain of
$6.2 million, which represented the cash receipt of
$8.6 million, less transaction related costs of
$2.4 million. The balance of $5.2 million of the purchase price will be
paid to the Company upon the Company achieving four remaining milestones over the subsequent 15
months and upon the release of the escrow. The agreement also sets forth representations and
warranties made by the Company that may cause it to incur liabilities and penalties arising out of
its failure to meet certain conditions and milestones. The maximum liability for the Company is
the greater of $11.5 million or the total amount of the purchase price paid by ATI plus $1.5
million. The gain on the sale of the assets, if any, will be
recognized upon completion of all milestones or when the
contingencies related to the sale are resolved. 15




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our condensed
consolidated financial statements and notes thereto. Overview We sell our digital video solution (DVS) products to cable operators, satellite providers and
television broadcasters. Additionally, we sell our home access solution (HAS) products, including
cable modems, embedded multimedia terminal adapters (eMTA), home
networking devices, and to a lesser extent cable
modem termination system (CMTS) product line to cable operators. On February 7, 2005, we entered into an agreement with ATI
Technologies, Inc (ATI) to sell certain cable modem semiconductors
assets to ATI for a total purchase price of up to $13.8 million
if we achieve all the milestones specified in the agreement. Under the
terms of the agreement, ATI acquired  our cable modem silicon
intellectual property and related software, assumed a lease and hired
approximately twenty-five employees from our design team. Upon
closing on March 9, 2005, we received $8.6 million in cash,
which was comprised of a $6.95 million initial payments and
$1.65 million of the $1.9 million for having met the first
milestone. ATI retained $0.25 million of the first milestone
payment to pay for retention bonuses to our former employees that
accepted employment with ATI. As of March 31, 2005, we had
deferred the net gain of $6.2 million, which represented the
cash receipt of $8.6 million, less transaction related costs of
$2.4 million. The balance of $5.2 million of the purchase
price will be paid to us upon our achieving four remaining milestones
over the subsequent 15 months and upon the release of the escrow. The
agreement also sets forth representations and warranties made by us
that may cause us to incur liabilities and penalties arising out of
our failure to meet certain conditions and milestones. The maximum
liability for us is the greater of $11.5 million or the total
amount of the purchase price paid by ATI plus $1.5 million. The
gain on the sale of the assets, if any, will be recognized upon
completion of all milestones or when the contingencies related to the
sale are resolved. We
have not been profitable since our inception. We had a net loss of
$2.6 million or $0.03
per share for the quarter ended March 31, 2005. Our ability to grow our business and attain
profitability is dependent on our ability to effectively compete in the marketplace with our
current products and services, develop and introduce new products and services, contain operating
expenses and improve our gross margins, as well as continued investment in equipment by the
broadband provider industry. At
March 31, 2005, we had approximately $99.8 million in
unrestricted cash, cash equivalents and short-term
investments as compared to approximately $97.7 million at December 31, 2004. The increase in the
first quarter of 2005 primarily resulted from the ATI transaction offset by the use of cash for
operating activities. A more detailed description of the risks to our business can be found in the section captioned
Risk Factors in this quarterly report. Critical Accounting Policies There have been no material changes to any of our critical accounting policies and estimates
as disclosed in our report on Form 10-K for the year ended December 31, 2004. 16




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##### Table of Contents



Results of Operations Comparison of three months ended March 31, 2005 and March 31, 2004 Revenues For the three months
    
    
    % Change for the threeended
    
    
    months endedMarch 31,
    
    
    March 31,(in thousands)
    
    2005
    
    
    2004
    
    
    2005/2004Revenues
    
    $
    26,363
    
    
    $
    41,168
    
    
    
    (36)%
 Our revenues decreased 36% for the quarter ended March 31, 2005 compared to the quarter ended
March 31, 2004. While sales of our DVS products increased, the overall decrease was primarily due
to decreased sales of our HAS and CMTS products. We expect overall revenues to increase on a sequential basis in 2005. Revenues by Groups of Similar Products % Change for the threeFor the three months ended
    
    
    months endedMarch 31,
    
    
    March 31,(in thousands)
    
    2005
    
    
    2004
    
    
    2005/2004Revenues by
product:DVS
    
    $
    13,046
    
    
    $
    6,071
    
    

    115
    %HAS
    
    
    11,569
    
    
    
    23,776
    
    

    (51
    )CMTS
    
    
    1,652
    
    
    
    11,135
    
    

    (85
    %)Other
    
    
    96
    
    
    
    186
    
    

    (48
    %)Total revenues
    
    $
    26,363
    
    
    $
    41,168
    
    

    (36

    %)
 Revenues from DVS products increased for the quarter ended March 31, 2005 compared to the
quarter ended March 31, 2004, due to significantly increased
sales to a United States major system
operator (MSO) of our DM 6400 product. We are encouraged by the prospects for the Video business
to grow and believe that we will continue to see increased sales of Video products as demand for
high definition television (HDTV) and other digital video services, including digital ad insertion,
grows in 2005. HAS revenues decreased for the quarter ended March 31, 2005 compared to the quarter ended
March 31, 2004, due to a decrease in modem sales. The number of DOCSIS modems sold decreased from
0.5 million in the first quarter of 2004 to 0.2 million in the same period in 2005. The intensely
competitive nature of the market for broadband products has resulted in significant price erosion
of Average Selling Prices (ASPs). We expect HAS revenues to continue
to decline in the remainder of
2005 when compared to the same period in 2004. CMTS revenues continued to decline for the quarter ended March 31, 2005 compared to the
quarter ended March 31, 2004, due to our decision to cease investment in the CMTS product line as
announced in the third quarter of 2004. We expect CMTS revenues to continue to decrease in 2005. Other revenues decreased for the quarter ended March 31, 2005 compared to the quarter ended
March 31, 2004, due to decreased sales of our legacy Telecom products. 17




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##### Table of Contents



Revenues by Geographic Region % Change for theFor the three months ended
    
    
    three months endedMarch 31,
    
    
    March 31,(in thousands)
    
    2005
    
    
    2004
    
    
    2005/2004Revenues by geographic areas:United States
    
    $
    15,267
    
    
    $
    21,832
    
    
    
    (30
    %)Americas, excluding
United States
    
    
    137
    
    
    
    1,639
    
    
    
    (92
    %)Europe, Middle East and
Africa, (EMEA),
excluding Israel
    
    
    4,186
    
    
    
    7,924
    
    
    
    (47
    %)Israel
    
    
    1,187
    
    
    
    3,284
    
    
    
    (64
    %)Asia excluding Japan
    
    
    5,565
    
    
    
    4,095
    
    
    
    36
    %Japan
    
    
    
    
    
    
    2,394
    
    
    
    (100
    %)Other
    
    
    21
    
    
    
    
    
    
    
    Total
    
    $
    26,363
    
    
    $
    41,168
    
    
    
    (36
    %)
 Revenues in the United States decreased in the first quarter of 2005 compared to the first
quarter of 2004, due to decreased sales of DOCSIS 2.0 CMTSs and modems to United States MSOs.
Revenues in EMEA, Israel, and Japan also decreased in the same period due to decreased sales of our
DOCSIS 2.0 CMTS and HAS products. During the first quarter of 2005, we continued to emphasize
sales to our United States and Asian customers while placing a lower emphasis on other locations
such as Canada, South America and Japan. In the remainder of 2005, we expect revenues to increase
in the United States and Asian markets. One customer, Harmonic, which
is a related party, accounted for 10% or more of total
revenues (33%) for the three months ended March 31, 2005. One customer, Adelphia accounted for 10%
of total revenues (24%) for the three months ended March 31, 2004. No other customer accounted for
more than 10% of revenues during these periods. Related Party Revenues % Change for theFor the three months ended
    
    
    three months endedMarch 31,
    
    
    March 31,(in thousands)
    
    2005
    
    
    2004
    
    
    2005/2004Related party revenues
    
    $
    8,827
    
    
    $
    745
    
    
    
    1,085
    %
 Related party revenues increased in the first quarter of 2005, compared to the first quarter
of 2004. Lewis Solomon, a member of our board of directors, is a member of the board of directors
of Harmonic. All revenues attributable to Harmonic were included in related party revenues in the
first quarter of 2005 and 2004. The increase in related party revenues was also due to an increase
of sales of our DVS products to Harmonic in the first quarter of 2005 as compared to the same
period in 2004. Harmonic is not a supplier to us. Cost of Goods Sold and Gross Profit % Change for theFor the three months ended
    
    
    three months endedMarch 31,
    
    
    March 31,(in thousands)
    
    2005
    
    
    2004
    
    
    2005/2004Cost of revenues
    
    $
    11,360
    
    
    $
    28,564
    
    
    
    (60
    %)Cost of related party
revenues
    
    
    1,683
    
    
    
    207
    
    
    
    713
    %Total cost of goods sold
    
    $
    13,043
    
    
    $
    28,771
    
    
    
    (55
    %)Gross profit
    
    $
    13,320
    
    
    $
    12,397
    
    
    
    7
    %
 Cost of goods sold consists of direct product costs as well as the cost of our manufacturing
operations. The cost of manufacturing includes contract manufacturing, test and quality assurance
for products, warranty costs and associated costs of personnel and equipment. In the first quarter
of 2005, cost of goods sold was approximately 49% of revenues compared to 70% of revenues in the
first quarter of 2004.

For the three months ended March 31, 2005 and March 31, 2004, our
gross margins were benefited by the reversal of approximately
$0.2 million and $1.3 million, respectively of accrued
vendor cancellation charges, which were previously recorded as cost
of revenues. Additionally, during the three months ended March 31,
2005 and March 31, 2004, our gross margins were benefited by the sale
of inventory of approximately $0.5 million and
$0.7 million, respectively, originally considered to be excess
or obsolete, which had been written off in prior periods. 18




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##### Table of Contents



In the first quarter of 2005, related party cost of revenues increased compared to the first
quarter of 2004 due to increased sales of our higher margin DVS products to Harmonic in the first quarter of 2005
as compared to sales in the first quarter of 2004. Our gross profit increased in the quarter ended March 31, 2005 compared to the same
period in 2004. The increase in our gross profit was primarily related to an improved sales mix,
with higher margin DVS products constituting a larger proportion of sales. During 2005, we will continue to focus on improving sales of higher margin products and
reducing product manufacturing costs. We are now partnering with contract manufacturers in Asia
and the U.S. for our HAS and DVS products, which may provide us with more competitive component
pricing, economies of scale, and improved manufacturing capabilities. Our endeavor to shift our
product mix from HAS revenues to higher margin DVS product revenues, may enable us to increase our
margins. However, there are no assurances that we will succeed in selling a greater percentage of
higher margin products or reducing our product manufacturing costs. Operating Expenses % Change for theFor the three months ended
    
    
    three months endedMarch 31,
    
    
    March 31,(in thousands)
    
    2005
    
    
    2004
    
    
    2005/2004Research and development
    
    $
    5,944
    
    
    $
    9,467
    
    
    
    (37
    %)Sales and marketing
    
    $
    5,673
    
    
    $
    7,221
    
    
    
    (21
    %)General and
administrative
    
    $
    2,795
    
    
    $
    2,436
    
    
    
    15
    %
 Research and Development.Research and development expenses consist primarily of personnel
costs, internally designed prototype material expenditures, and expenditures for outside
engineering consultants, equipment and supplies required to develop and enhance our products.
Research and development expenses decreased 37% to $5.9 million or 23% of sales in the first
quarter of 2005 from $9.5 million or 23% of sales in the same period in 2004. The $3.5 million
decrease in research and development expenses was attributable to $2.0 million of reductions in
employee related expenses, $1.2 million decrease in allocations of overhead, and $0.6 reduction of
other expenses, partially offset by an increase of
$0.3 million of outside engineering consultants. We believe it is critical for the Company to
continue to make significant investments in research and development to create innovative
technologies and products that meet the current and future requirements of our customers.
Accordingly, we intend to continue our investment in research and development although at lower
levels compared to 2004. Sales and Marketing. Sales and marketing expenses consist primarily of salaries and
commissions for sales personnel, and marketing and support personnel,
and costs related to marketing communications, consulting and travel. Sales and marketing expenses decreased by $1.5 million to $5.7
million or 22% of sales in the first quarter of 2005 from $7.2 million or 18% of sales in the same
period in 2004. The decrease in sales and 19




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##### Table of Contents



marketing expenses was primarily due to $0.4 million in
decreased employee expenses due to decreased headcount, $0.2 million of decreased spending for
outside consultants, $0.2 million of decreased travel costs, $0.4 million of decreased corporate
aircraft expenses, and $0.3 million of overall sales and marketing cost reductions. We currently
expect sales and marketing expenses to increase in 2005 as we recruit additional sales and
marketing personnel to sell our higher margin Video products and increase our marketing
communications efforts. General and Administrative. General and administrative expenses consist primarily of salary
and benefits for administrative officers and support personnel, travel expenses and legal,
accounting and consulting fees. General and administrative expenses increased by $0.4 million to
$2.8 million or 11% of sales in the quarter ended March 31, 2005 from $2.4 million or 6% of sales
in the same period in 2004. The increase was primarily due to $0.2 million of increased spending
for outside consultants and $1.7 million increase in allocations of overhead, partially offset by a
$0.6 million reduction in our allowance for doubtful accounts
credited to general and administrative
expense, $0.3 million in reduced employee expenses due to lower headcount, and $0.6 million of
overall general and administrative cost decreases. Restructuring Costs and Asset Write-offs For the three monthsMarch 31,(in thousands)
    
    2005
    
    
    2004Restructuring charges
    
    $
    1,197
    
    
    $
    3,261Long-lived assets written-off
    
    
    85
    
    
    
    106Restructuring costs and asset write-offs
    
    $
    1,282
    
    
    $
    3,367
 Restructuring
CostsDuring the first quarter of 2004, we initiated a
restructuring plan to bring operating expenses in line with revenue
levels. We
incurred restructuring charges in the amount of $3.3 million of which $1.0 million related to
employee termination costs, $0.9 million related to exit costs for an aircraft lease, and $1.4
million related to costs for excess leased facilities. In the first quarter of 2005, we increased
the 2004 restructuring charge by $1.4 million relating to the
revaluation of revenues of which $0.7 million is related to the
termination of CMTS engineers in the second quarter of 2005 and $0.7
million is related to an additional reserve for our excess leased
facilities. The balance remaining for all 2004 restructuring
charges was $3.7 million at March 31, 2005. We anticipate the remaining restructuring accrual
related to employee termination costs to be substantially utilized in the second quarter of 2005.
The remaining restructuring accrual related to the aircraft lease is expected to be substantially
utilized for servicing operating lease payments
through January 2007, and the remaining restructuring accrual related to excess leased
facilities, is expected to be utilized for servicing operating lease payments or negotiating a
buyout of operating lease commitments, through October 2009.
During the second quarter of 2005, we expect to record additional
restructuring charges in the range of $0.5 million to
$1.0 million primarily related to planned and final personnel
reductions of CMTS engineers. The reserve for the aircraft lease and excess leased facilities was based on information
provided by our brokers that estimated, based on assumptions relevant to the aircraft and real
estate market conditions as of the date of our restructuring plan, the time it would be likely to
take until the aircraft and excess leased facilities would be fully sub-leased. Even though it is
our intent to sublease, assign or sell our interests in the aircraft and excess facilities at the
earliest possible time, we cannot determine with certainty a fixed date by which such events will
occur. In light of this uncertainty, we will periodically re-evaluate and adjust the reserve, as
necessary. In the third quarter of 2002, we initiated a restructuring program. As part of this program,
we restructured our worldwide operations including a worldwide reduction in workforce and the
consolidation of excess leased facilities. We incurred additional restructuring charges of $3.6
million related to the 2002 restructuring. Of the total restructuring charge, $2.3 million was
related to employee termination costs. The remaining $1.3 million related primarily to costs for
excess leased facilities. At March 31, 2005, restructuring charges of $15,000 remained accrued. In 2001 we incurred restructuring charges of $12.7 million. Of the total restructuring
charges recorded, $3.2 million related to employee termination costs covering 293 technical,
production, and administrative employees. The remaining $9.5 million of restructuring charges
related primarily to costs 20




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for excess leased facilities. As of March 31, 2005, restructuring
charges of $1.1 million remained accrued. We anticipate utilizing the remaining restructuring
accrual, which relates to servicing operating lease payments of operating lease commitments,
through 2005. Executive Severance
    In 2004, we entered into employment agreements with three executive officers who subsequently
resigned. Most of the severance costs related to these officers were paid in 2004.
Approximately $29,000 of employee benefits for the executive officers remain accrued,
which are expected to be paid through 2005. Asset
Write-offs    We wrote off $0.1 million in each of the three months ended March 31, 2005
and March 31, 2004, of fixed assets related to restructuring activities, which were determined to
have no remaining useful life. Additionally, in the three months ended March 31, 2005, we wrote off
$0.2 million of fixed assets, which were charged to other income (loss). We did not write off any
additional assets in the three months ended March 31, 2004. Non-operating Expenses % Change for theFor the three months ended
    
    
    three months endedMarch 31,
    
    
    March 31,(in thousands)
    
    2005
    
    
    2004
    
    
    2005/2004Interest income
    
    $
    568
    
    
    $
    452
    
    
    
    26
    %Interest expense
    
    $
    (814
    )
    
    $
    (819
    )
    
    
    (1
    %)Other income expense
    
    $
    66
    
    
    $
    280
    
    
    
    (76
    %)
 Interest Income. Interest income increased in the first quarter of 2005 compared to the
same period in 2004. The increase in interest income was primarily due to slightly higher interest
rates. Interest Expense. Interest expense, which related primarily to interest on our Convertible
Subordinated Notes (Notes) due in 2007, remained relatively flat in the first quarter of 2005
compared to the same period in 2004. Other Income.Other income is generally comprised of realization of foreign currency
gains and losses, realized gains or losses on investments, and income attributable to non-operational gains and losses. Other income in the first quarter of 2005 decreased when compared to the same period in 2004, due to the decrease of
non-operational gains related to the sale of discontinued inventory. Income Taxes For the three monthsendedMarch 31,(in thousands)
    
    2005
    
    
    2004Income tax expense
    
    $
    (50
    )
    
    $
    (66
    )
 We
have generated losses since our inception. In each of the first quarter of 2005 and 2004, we
recorded an income tax expense related primarily to foreign taxes. Litigation See Part II, Item 1 Legal Proceedings. Off-Balance Sheet Financings and Liabilities Other than lease commitments and unconditional purchase obligations incurred in the
normal course of business, we do not have any off-balance sheet financing arrangements or
liabilities, guarantee contracts, retained or contingent interests in transferred assets or any
obligation arising out of a material variable interest in an unconsolidated entity. We do not have
any majority-owned subsidiaries that are not included in the consolidated financial statements. Liquidity and Capital Resources At March 31, 2005, we had approximately $30.6 million in unrestricted cash and cash equivalents and $69.2
million in short-term investments. 21




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In July 2000, we
issued $500.0 million of Notes, resulting in net proceeds to us of approximately $484.4
million. The Notes are a general unsecured obligation and are subordinated in right of
payment to all of our existing and future senior indebtedness and to all of the liabilities
of our subsidiaries. The Notes are convertible into shares of our common stock at a conversion
price of $84.01 per share at any time on or after October 24, 2000 through maturity,
unless previously redeemed or repurchased. Interest is payable semi-annually. Debt issuance
costs related to the Notes were approximately $15.6 million. The Notes mature in August 2007. Through March 31, 2005,
we had repurchased approximately $434.9 million of the Notes for $171.0 million in cash
and $17.9 million in stock, resulting in a gain on early retirement
of debt of approximately $234.4 million net of related unamortized issuance costs of $11.6 million in prior periods.
No Notes were repurchased in 2003, 2004, or 2005. Cash used in operating activities for the quarter ended March 31, 2005 was $6.2 million
compared to $15.1 million in the same period in 2004. In the first quarter of 2005, significant
uses of cash from operating activities included $2.6 million loss from operations and $1.8 million
of increase in gross inventory. Inventory levels increased at March 31, 2005 when compared to
December 31, 2004 due to increased modem and video inventories in order to meet service levels
established with our key customers. In the quarter ended March 31, 2004, significant uses of cash
from operating activities included a $10.2 million loss from operations, $4.7 million decrease in
accounts payable, and $3.5 million of increase in gross inventory. Cash used in investing activities for the quarter ended March 31, 2005 was $7.6 million
compared to cash provided by investing activities of $60.4 million in the same period in 2004.
Investing activities consisted primarily of net purchases and sales of short-term investments in
the first quarter of 2005 and 2004. Net cash provided by investment activities during the first quarter of 2005 also consisted of proceeds from the sale of our semiconductor assets to ATI described below.
Net cash used in investing activities in the first quarter of
2005 was due to movement of short-term investments to cash and cash equivalents. Net cash provided
by investing activities in the first quarter of 2004 is due to movement of cash and cash

equivalents to short-term investments. On February 7, 2005,
we entered into an agreement with ATI Technologies, Inc (ATI) to sell certain cable modem
semiconductor assets to ATI for a total purchase price of up to $13.8 million if we achieve
all the milestones specified in the agreement. Under the terms of the agreement,
ATI acquired our cable modem silicon intellectual property and related software, assumed a
lease and hired approximately twenty-five employees from our design team. Upon closing on
March 9, 2005, we received $8.6 million in cash, which was comprised of a $6.95 million
initial payment and $1.65 million of the $1.9 million for having met the first milestone.
ATI retained $0.25 million of the first milestone payment to pay for retention bonuses to our
former employees that accepted employment with ATI. As of March 31, 2005, we had deferred
the net gain of $6.2 million, which represents the cash receipt of $8.6 million, less
transaction related costs of $2.4 million. The balance of $5.2 million of the purchase
price will be paid to us upon our achieving four remaining milestones over the subsequent 15
months and upon the release of the escrow. The agreement also sets forth representations and
warranties made by us that may cause us to incur liabilities and penalties arising out of
our failure to meet certain conditions and milestone. The maximum liability for us is the
greater of $11.5 million or the total amount of the purchase price paid by ATI plus $1.5
million. The gain on the sale of the assets, if any, will be recognized upon completion of
all milestones or when the contingencies related to the sale are resolved. Cash provided by financing activities was $1.3 million in the first quarter of 2005 primarily due to proceeds from the exercise of stock options. Cash provided by financing activities was $0.7 million in the same period in 2004 primarily due to proceeds from the exercise of stock
options and the sale of shares of common stock through our Employee Stock Purchase Plan in 2004. We currently believe that our current unrestricted cash, cash equivalents, and short term investment balances will be sufficient to satisfy our cash
requirements for at least the next 12 months. In order to achieve profitability in the future, we
will need to increase revenues, primarily through sales of more profitable products, and decrease
costs. These statements are forward-looking in nature and involve risks and uncertainties. Actual
results may vary as a result of a number of factors, including those discussed under the risk
factor Our Operating Results May Fluctuate below and elsewhere. We may need to raise additional
funds in order to support more rapid expansion, develop new or enhanced services, respond to
competitive pressures, acquire complementary businesses or technologies or respond to unanticipated
requirements. We may seek to raise additional funds through private or public sales of securities,
strategic relationships, bank debt, and financing under leasing arrangements or otherwise. If
additional funds are raised through the issuance of equity securities, the percentage ownership of
our current stockholders will be reduced, stockholders may experience additional 22




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dilution or such
equity securities may have rights, preferences or privileges senior to those of the holders of our
common stock. We cannot assure you that additional financing will be available on acceptable terms,
if at all. If adequate funds are not available or are not available on acceptable terms, we may be
unable to continue operations, develop our products, take advantage of future opportunities or
respond to competitive pressures or unanticipated requirements, which could have a material adverse
effect on our business, financial condition and operating results. Contractual Obligations The following summarizes our contractual obligations at March 31, 2005, and the effect such
obligations are expected to have on our liquidity and cash flows in future periods (in millions): Payments Due by PeriodLess than
    
    
    1-3
    
    
    4-5
    
    
    After 5Total
    
    
    1 year
    
    
    years
    
    
    years
    
    
    yearsUnconditional Purchase Obligations
    
    $
    24.1
    
    
    $
    24.1
    
    
    $
    
    
    
    $
    
    
    
    $
    Long Term Debt
    
    
    65.1
    
    
    
    
    
    
    
    65.1
    
    
    
    
    
    
    
    Operating Lease Obligations
    
    
    16.5
    
    
    
    5.0
    
    
    
    6.5
    
    
    
    4.9
    
    
    
    0.1Aircraft Lease Obligations
    
    
    2.7
    
    
    
    1.5
    
    
    
    1.2
    
    
    
    
    
    
    
    Total Contractual Commitments
    
    $
    108.4
    
    
    $
    30.6
    
    
    $
    72.8
    
    
    $
    4.9
    
    
    $
    0.1
 We have unconditional purchase obligations to certain of our suppliers that support our
ability to manufacture our products. The obligations require us to purchase minimum quantities of
the suppliers products at a specified price. As of March 31, 2005, we had approximately $24.1
million of purchase obligations, of which $0.4 million is included in the Condensed Consolidated Balance
Sheets as accrued vendor cancellation charges, and the remaining $23.7 is attributable to open
purchase orders. The remaining obligations are expected to become payable at various times through
2005. Other commercial commitments, primarily required to support operating leases, are as follows
(in millions): Amount of Commitment Expiration Per PeriodTotalAmounts
    
    
    Less than
    
    
    1-3
    
    
    4-5
    
    
    Over 5Committed
    
    
    1 year
    
    
    years
    
    
    years
    
    
    yearsDeposits
    
    $
    7.5
    
    
    $
    
    
    
    $
    7.5
    
    
    $
    
    
    
    $
    Standby Letters of Credit
    
    
    1.2
    
    
    
    0.9
    
    
    
    
    
    
    
    0.3
    
    
    
    Total Commercial Commitments
    
    $
    8.7
    
    
    $
    0.9
    
    
    $
    7.5
    
    
    $
    0.3
    
    
    $
    
 In 2002, we entered into an operating lease arrangement to lease a corporate aircraft. This
lease arrangement was secured by a $9.0 million letter of credit. The letter of credit was reduced
to $7.5 million in February 2003. During 2004 the $7.5 million letter of credit was converted to a
cash deposit. This lease commitment is included in the table above. In March 2004, in connection
with our worldwide restructuring, we notified the lessor of our intentions to locate a purchaser
for our remaining obligations under this lease. In August 2004, we entered into an agreement with a third party to sublease the corporate aircraft through December 31, 2006. Impact of Recently Issued Accounting Standards On December 16, 2004,
the Financial Accounting Standards Board (FASB)
 issued SFAS 123 (revised 2004), (SFAS 123(R)), Share-Based Payment, which
replaces SFAS 123, Accounting for Stock-Based Compensation, and supersedes
APB 25, Accounting for Stock Issued to Employees.
 Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123.
SFAS 123(R) eliminates the alternative to use APB 25s intrinsic value method of accounting
that was provided in SFAS 123 as originally issued. After a phase-in period for SFAS 123(R),
pro forma disclosure will no longer be allowed. The SEC announced in the second
quarter of 2005 that it would extend this phase-in period and, therefore, our effective
date for implementation of SFAS 123(R) is January 1, 2006. We have not yet determined which
phase-in method it will adopt. In the first quarter of 2005 the Securities and Exchange
 Commission (SEC) issued Staff Accounting Bulletin No. 107 which provided further
clarification on the implementation of SFAS 123(R). As permitted by
SFAS 123, we currently account for share-based payments to employees using APB 25s
intrinsic value method and, as such, generally recognize no compensation expense for
employee stock options. Accordingly, the adoption of SFAS 123(R)s fair value method
will likely have a material impact on our results of operations, although it will have
no impact on our overall financial position. See Stock Based Compensation, above
for information related to the pro forma effects on our reported net loss and net loss per
common share of applying the fair value recognition provisions of the previous SFAS 123
to stock-based employee compensation. In November 2004, the
FASB issued SFAS 151, Inventory Costs, which revised Accounting Research Bulletin
 No. 43 (ARB 43), relating to inventory costs. This revision is to clarify the
accounting for abnormal amounts of idle
facility expense, freight, handling costs and wasted material (spoilage). SFAS 151
requires that these items be recognized as a current period charge regardless of whether
they meet the criterion
 specified in ARB 43. In addition, SFAS 151 requires the allocation of fixed production
overheads to the costs of conversion be based on normal
 capacity of the production facilities. SFAS 151 is effective for inventory costs incurred
during fiscal years beginning after June 15, 2005. We do not believe the adoption of SFAS 151
will have a material impact on our financial statements. 23




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RISK FACTORS You should carefully consider the risks described below before making an investment decision. The
risks and uncertainties described below are not the only ones facing us. Additional risks and
uncertainties not presently known to us or that we currently deem immaterial also may impair our
business operations. If any of the following risks actually occur, our business could be harmed.
In such case, the trading price of our common stock could decline, and you may lose all or part of
your investment. Risks Related to Our Business We have a history of losses and may continue to incur losses in the future It is difficult to predict our future operating results. We began shipping products
commercially in June 1997, and we have been shipping products in volume since the first quarter of
1998. As of March 31, 2005, we had an accumulated deficit of approximately $1.0 billion. We believe
that we will continue to experience challenges in selling our products at a profit and may continue
to operate with net losses for the foreseeable future. In the past few years, we experienced a
decrease in revenues compared to 2001 and 2000, in large part, due to the erosion of average
selling prices (ASPs) of our products due to our transition from a proprietary platform to the Data
Over Cable System Interface (DOCSIS) standards platform and a drop in sales volume of cable modem
termination systems (CMTS). Our revenue decreased for the three months ended March 31, 2005 to
$26.3 million from $41.2 million in the same period in 2004. We also incurred losses of $36.5
million and $50.4 million, respectively, in the twelve months ended December 31, 2004 and 2003. As
a result of our losses, we have had to use available cash and cash equivalents to
supplement the operation of our business. Additionally, we generally have been unable to significantly reduce our short-term expenses
in order to compensate for unexpected decreases in anticipated revenues or delays in generating
anticipated revenues. For example, we have fixed commitments with some of our suppliers that
require us to purchase minimum quantities of their products at a specified price irrespective of
whether we can subsequently use such quantities in our products. Further, we have experienced and
will likely continue to experience declining ASPs of our products. In addition, we have significant
operating lease commitments for facilities and equipment that generally cannot be cancelled in the
short-term without substantial penalties, if at all. We may continue to experience fluctuations in our operating results and face unpredictability in
our future revenues Our quarterly revenues have fluctuated and are likely to continue to fluctuate significantly
in the future due to a number of factors, many of which we cannot control. Factors that affect our
revenues include, among others, the following:  
    variations in the timing of orders and shipments of our products; 24




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
    variations in the size of the orders by our customers and pricing concessions on volume sales;
    competitive market conditions;
    unpredictable sales cycles;
    new product introductions by competitors or by us;
    delays in our introduction of new products;
    delays in our introduction of added features to our products;
    delays in the commercialization of products that are competitive in the marketplace;
    delays in our receipt of and cancellation of orders forecasted by customers;
    variations in capital spending budgets of cable operators and other broadband service providers;
    international conflicts, including the continuing conflict in Iraq, and acts of
terrorism and the impact of adverse economic, market and political conditions worldwide;
and
    ability of our products to be qualified or certified as meeting industry standards. Our quarterly results are affected by the gross margin we achieve for the quarter relative to
our gross revenues. A variety of factors influence our gross margin for a particular quarter,
including, among others, the following:  
    the sales mix of our products;
    the volume of products manufactured;
    the type of distribution channel through which we sell our products;
    the ASPs of our products;
    our ability to manage excess and obsolete inventory;
    delays in reducing the cost of our products;
    the costs of manufacturing our products; and
    the effectiveness of our cost reduction measures. We often recognize a substantial portion of our revenues in the last month of the quarter. We
establish our expenditure levels for product development and other operating expenses based on
projected sales levels, and expenses are relatively fixed, particularly in the short term. For
example, a significant percentage of these operating expenses are fixed due to operating leases for
our facilities and equipment. Also, we have fixed commitments with some of our suppliers that
require us to purchase minimum quantities of their products at a specified price. Because in the
past, we have been unable to use all of the products that we purchased from our suppliers, we have
taken vendor cancellation charges as a result of these fixed commitments, and we may have to take
additional charges in the future if we are unable to use all of the products that we purchase from
our suppliers. As of March 31, 2005, $24.1 million of purchase obligations were outstanding.
The remaining obligations are expected to become payable at various times throughout 2005. Accordingly, variations in timing of sales can cause significant fluctuations in operating results.
In addition, because a significant portion of our business is derived from orders placed by a
limited number of large customers, the timing of such orders can also cause significant
fluctuations in our operating results. Our expenses for any given quarter are typically based on
expected sales and if sales 25




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are below expectations; our operating results may be adversely impacted
by our inability to adjust spending to compensate for the shortfall. Moreover, our research and
development expenses fluctuate in response to new product development, and changing industry
requirements and customer demands. Additionally, the unit ASPs of our HAS products declined considerably in 2004, 2003, and 2002,
and we anticipate that unit ASPs of our HAS products will continue to decline in the future. This
has caused and will continue to cause a decrease in our gross margins if we are unable to offset
the decline in ASPs of our HAS products with cost reduction measures. In addition, the gross
margins we realize from the sale of our products are affected by the mix of product sales between
higher margin, lower volume digital video solutions (DVS) products and applications and lower
margin, higher volume HAS products. We are attempting to increase our gross margin by increasing
the sale of our DVS products, cost-reducing the HAS products, and ceasing investment in our CMTS
product line. However, there are no assurances that we will succeed. For 2005, we expect that sales
of our low-margin HAS products will continue to make up a significant portion of our revenues. If
we do not generate a greater percentage of total revenues from our DVS product revenues, we will
not succeed in greatly improving our gross margin. 26




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We are dependent on a small number of customers and resellers and our business could be harmed
by the loss of any of these customers or reductions in their purchasing volumes Our customers have undergone and continue to undergo significant consolidation in both North
America and internationally, as a limited number of cable operators control an increasing number of
systems. For example, the top nine cable operators in the United States operate systems that
service approximately 90% of homes that receive cable services in the United States. As a result of
the consolidation among cable operators, our revenue has been and will continue to be dependent on
sales to the few leading cable operators worldwide. One customer, Harmonic, which is also a related party, accounted for 10% or
more of total revenues (33%) for the three months ended March 31, 2005. One customer, Adelphia
 accounted for 10% of total revenues (24%) for the three months ended March 31, 2004. Adelphia is
not expected to be a customer in 2005 due to our decision to cease investment in our CMTS product
line, which may have a material adverse effect on our business or results of operations in 2005. As
is common in our industry, we typically do not enter into contracts with our customers in which
they commit to purchase products from us. Typically, our sales are made on a purchase order or
system contract basis, and none of our customers has entered into a long-term agreement requiring
it to purchase our products. Moreover, we do not typically require our customers to purchase a
minimum quantity of our products, and our customers can generally cancel or significantly reduce
their orders on short notice without significant penalties. The loss of any of our customers can
have a material adverse effect on our results of operations. Further, any reduction in orders from
a given customer also may have a material adverse affect on our results of operations. Significant sales of our DVS products are made to a small number of resellers, who often
incorporate our DVS products and applications in systems that are sold to an end-user customer,
which is typically a cable operator, satellite provider or broadcast operator. If one or more of
these resellers develop their own products or elect to purchase similar products from another
vendor, our revenue and results of operations may suffer. Also, we may not succeed in attracting new customers as many of our potential customers have
pre-existing relationships with our current or potential competitors and the continued
consolidation of the cable industry reduces the number of potential customers. To attract new
customers, we may be faced with intense price competition, which may affect our gross margins. We may also lose existing customers or experience declining business in our DVS and HAS
products from our existing customers because of our decision to cease investment in our CMTS
product line. For example, Adelphia, one of our largest CMTS customers, indicated that it will no
longer purchase HAS or DVS products from us. The loss of Adelphia and the loss of any additional
CMTS customers that decrease or cease their purchases of DVS and HAS products could materially
adversely affect our business and results of operations. Recent changes in senior management and the reductions in workforce associated with our
restructuring efforts could disrupt the operation of our business, distract our management from
focusing on revenue- generating efforts, result in the erosion of employee morale, and impair our
ability to respond rapidly to growth opportunities in the future We have experienced a number of recent changes in senior management and other key personnel.
Our Chief Executive Officer, President and Chief Technology Officer, Chief Operating Officer, Chief
Financial Officer and General Counsel all resigned within the latter half of 2004. Our new Chief
Executive Officer was appointed in September 2004 and our new Chief Financial Officer was appointed
in late November 2004. We also have recently experienced increased turnover in our video
engineering group and finance organization. The recruitment and retention of a new senior
management staff and turnover in key personnel has created and could continue to create a number of
transitional challenges for us. These transitional issues have caused, and may cause, disruptions
to our business. We cannot be assured that a smooth transition of our senior management staff has
occurred, or that we have taken the necessary steps to effect an orderly continuation of our
operations during the transitional period. Further, the process of locating personnel with the
combination of skills and attributes required to carry out our goals and integrating such personnel
once they are recruited is often lengthy. We cannot be assured that the 27




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integration of our new senior management staff will occur in a timely manner, or that such
integration will not present additional transitional challenges for us or adversely affect the
operation of our business. Moreover, we have implemented a number of restructuring plans since 2001, including the most
recent restructuring activities in 2004 that resulted in personnel reduction of 40%. The employee
reductions and changes in connection with our restructuring activities, as well as future changes
in senior management and key personnel, could result in an erosion of morale, and affect the focus
and productivity of our remaining employees, including those directly responsible for revenue
generation and the management and administration of our finances, which in turn may adversely
affect our revenue in the future or cause other administrative deficiencies. Additionally,
employees directly affected by the reductions may seek future employment with our business
partners, customers or competitors. Although all employees are required to sign a proprietary
information agreement with us at the time of hire, there can be no assurances that the confidential
nature of our proprietary information will be maintained in the course of such future employment.
Additionally, we may face wrongful termination, discrimination, or other claims from employees
affected by the reduction related to their employment and termination. We could incur substantial
costs in defending ourselves or our employees against such claims, regardless of the merits of such
actions. Furthermore, such matters could divert the attention of our employees, including
management, away from our operations, harm productivity, harm our reputation and increase our
expenses. We cannot assure you that our restructuring efforts will be successful, and we may need
to take additional restructuring efforts, including additional personnel reduction, in the future. We are dependent on key personnel Due to the specialized nature of our business, we are highly dependent on the continued
service of, and on our ability to attract and retain qualified senior management, engineering,
sales and marketing personnel and employees with significant experience and expertise in video,
data networking and radio frequency design. The competition for some of these personnel is intense,
particularly for engineers with Moving Picture Experts Group (MPEG) experience We may incur
additional expenses to attract and retain key personnel. There can be no assurances that the
additional expenses we may incur, or our efforts to recruit such
individuals will be successful, and if they are not, our business may
significantly experience
disruption or adverse effects. In addition, if we are unable to hire qualified personnel
as needed in a timely manner, we may be unable to adequately manage and grow our business. We do not have key person insurance coverage for the loss of any of our employees. Any officer
or employee can terminate his or her relationship with us at any time. Our employees generally are
not bound by non-competition agreements. There are many risks associated with our participation in industry standards In connection with the development of the DOCSIS 2.0 specification by CableLabs, a cable
industry consortium that establishes cable technology standards and administers compliance testing,
we entered into an agreement with CableLabs whereby we licensed to CableLabs on a royalty-free
basis any of our intellectual property rights, including rights to our proprietary S-CDMA
technology, to the extent that such rights may be asserted against a party desiring to design,
manufacture or sell DOCSIS based products, including DOCSIS 2.0 based products. This license
agreement grants to CableLabs the right to sublicense our intellectual property, including our
intellectual property rights in our S-CDMA patents, to manufacturers that compete with us in the
marketplace for DOCSIS based products. As a result of this license to CableLabs, our competitors
that produce DOCSIS-based products have access to our technology without having to pay us any
royalties or other compensation for the use of our technology. As a result of our contribution of
technology to the DOCSIS intellectual property pool, we may have foregone significant revenue from
the potential licensing of our proprietary technology, and we may be unable to recoup the
investment in the research and development of intellectual property contributed to the DOCSIS
technology pool. Additionally, the agreement that we signed with CableLabs to participate in the DOCSIS
intellectual property pool may make it difficult for us to enforce our intellectual property rights
against other 28




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companies. Certain cable equipment vendors manufacture and sell DOCSIS based and DOCSIS
certified and qualified products without sublicensing from CableLabs the technology in the
CableLabs intellectual property pool. Due to the interests of cable operators in having as many
equipment vendors as possible, we may feel constrained by competitive pressures from pursuing the
enforcement of our intellectual property rights against our competitors that have not entered into
sublicenses with CableLabs. Moreover, if we seek to enforce our intellectual property rights
against other equipment manufacturers that access technology from the CableLabs intellectual
property pool, our license to the technology in the pool may be jeopardized. Certain contributors
of technology to the CableLabs intellectual property pool are our competitors and may elect to
revoke our license to their technology if we attempt to enforce our intellectual property rights
against them. We may have lost any competitive advantage that our proprietary S-CDMA technology may have
provided us in the marketplace by licensing it to CableLabs and we may lose any competitive
advantage that any other proprietary technology that is licensed to CableLabs. Additionally, we may
face increased competition because our competitors have the ability to incorporate our technology
into their products. We believe that this increased competition could come from existing
competitors or from new competitors who enter the market and that such competition is likely to
result in lower product ASPs, which could harm our revenues and gross margins. Additionally,
because our competitors will be able to incorporate our technology into their products, our current
customers may choose alternate suppliers or choose to purchase DOCSIS-compliant products from
multiple suppliers. We may be unable to effectively compete with the other vendors if we cannot
produce DOCSIS compliant cable products more quickly or at lower cost than our competitors. DOCSIS specifications have not yet been accepted in Asia, although an increasing number of
Asian cable operators are requiring product to be DOCSIS qualified or certified. A related
specification for cable products, called the Euro-DOCSIS specification, has been formalized by
TComLabs, a cable technology consortium of European cable operators, and European and some Asian
cable operators have embraced it. We have contributed certain of our technologies, including our
proprietary S-CDMA technology, to the Euro-DOCSIS specification. We may develop and sell products
that comply with the Euro-DOCSIS specification, and we may be unsuccessful in these efforts. Even
if we are successful in our efforts, we may face some of the same risks associated with our
contribution of intellectual property to the CableLabs DOCSIS intellectual property pool. We need to certify and qualify our new and existing products to meet industry specifications in
order to remain competitive Major cable operators worldwide have endorsed the DOCSIS, Euro-DOCSIS and PacketCable
specifications and rarely purchase data and voice equipment that is not certified or qualified as
compliant with these specifications. Although there is currently no specification for DVS products,
if such a specification is adopted, then we will not only need to
certify our video products with such specifications, but we may
experience more intense price competition for our DVS products and
erosion in ASPs. In
addition, we currently need to certify our HAS products. Traditionally, cable operators have chosen
to purchase only products meeting industry specifications because the specifications enable
interoperability among products from multiple vendors, which leads to increased competition among
equipment manufacturers and consequently lowers product ASPs. As a result, our future success
depends on our ability to compete effectively in this marketplace by developing, marketing and
selling products that are certified and qualified to industry standards in a timely and cost
effective manner. The DOCSIS and PacketCable specifications are promulgated by CableLabs. Currently these
specifications have been widely adopted by cable operators in North America and by some cable
operators in Asia, Latin America and Europe. The Euro-DOCSIS specifications have been developed by
TComLabs specifically to meet the requirements of European operators, and have found some
acceptance in China as well. There is no guarantee that our products will continue to be DOCSIS,
EuroDOCSIS or PacketCable certified or qualified, or will be certified for any new standards that
may emerge. If we are unable to certify or qualify our products as compliant with DOCSIS,
EuroDOCSIS or PacketCable or other applicable standards in a timely manner, we may be unable to
sell our products and may lose some or all of any advantage we might otherwise have had, and our
future operating results may be adversely affected. 29




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Although we sell certified and qualified data and voice products, there have been and may
continue to be instances where our existing customers and potential new customers elect to purchase
products from one or more of our competitors rather than from us. In response, we have reduced our
prices and continue to experience customer demand to further reduce our prices in order to promote
sales of our current products. This has had and may continue to have an adverse impact on our
revenues, operating results and gross margin. Developing products to meet these various industry specifications has several risks. The first
is the cost and effort to engineer standards-based products and to then prepare them for compliance
testing. Not only do we have to certify or qualify new products, but any of our currently certified
or qualified products must be re-certified or re-qualified should they be changed in any way.
Second, there is no guarantee that these products will be certified or qualified as meeting these
specifications in a timely fashion, if ever. Because most cable operators purchase only those
products that have been certified or qualified as meeting these specifications, it is highly
unlikely that we will be able to sell our products until they achieve certification or
qualification, which can be a lengthy process. As a result, we may incur significant research and
development expenses to develop new products that may not receive certification or qualification
and we cannot recoup the costs of these research and development expenses by marketing uncertified
or unqualified products. Moreover, a consequence of cable operators only purchasing products
certified or qualified as meeting industry specifications is the increased competition between
equipment vendors, which has resulted in a steady and ongoing decline in equipment prices as
vendors compete for cable operators business. Third, there is no guarantee that we will be able to
support all future cable industry specifications, which will likely have an adverse impact on our
future revenues. Our video products and applications must achieve widespread market acceptance to advance the growth
of our digital video solutions business Our success depends upon the widespread acceptance of our video products and applications by
broadband providers. Traditionally, we have had success selling our CherryPicker and DM products to
cable operators and satellite providers; however, there is no guarantee that this success will
continue as the products and applications evolve and as new competitors enter the market. In 2004,
we introduced our BP5100, which is our product geared towards television broadcasters. Currently,
we have had one large deployment of BP5100 and have had limited sales of the BP5100 through resale
channels. We are currently developing technology for the deployment of video for the telecom
carriers; however, there is no guarantee that we will continue to pursue that development, that our
product will work or that our product will find widespread acceptance among the telecom carriers. The emerging market trend to standardize the digital video technology may challenge our ability to
continue to grow our digital video business Comcast Corporation, Time-Warner, Inc. and Cox Communications, Inc., the three largest cable
operators in the United States, started their Next-Generation Network Architecture (NGNA)
initiative in 2003 to develop a common approach to transform their cable systems into all-digital
networks. This initiative could potentially impact video technology, including our video technology
and products. As a group, the operators can work more effectively with equipment vendors in
defining the products and product capabilities required for the migration. In 2004, the
participating operators commissioned CableLabs to manage the NGNA initiative and to develop a set
of standards to which equipment vendors can build their products. The NGNA initiative is so far
following the model successfully proven with the earlier DOCSIS initiative, which enabled the
development of interoperable cable modems, CMTSs and other associated equipment that allowed United
States operators to rollout broadband cable modem service much faster, more broadly and with
greater success than telecom carriers could offer their competing DSL service. As it has with data
services, CableLabs may request companies to contribute their video technologies to a DOCSIS-like
technology pool on a royalty-free basis. If we contribute any of our video technology to a
DOCSIS-like technology pool, our video technology is subject to the same risks as those associated
with the standards-based technology for our data services, which are discussed above. 30




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Subject to the success of the initiative, cable operators may want to purchase only video
products that have been certified or qualified by CableLabs, in which case we will not be able to
sell our video products until they achieve certification or qualification, which, based on our
experience with our data services, can be a lengthy process. As a result, we may incur significant
research and development expenses to develop new video products that may not receive certification
or qualification and we may not be able to recoup the costs of these research and development
expenses by marketing uncertified or unqualified products. Moreover, there is no guarantee that we
will be able to support all future specifications relating to video products, which would likely
have an adverse impact on our future revenues. Furthermore, a consequence of cable operators
purchasing only certified or qualified products, based on our experience with the data services, is
the increased competition between equipment vendors, which would result in a steady and ongoing
decline in equipment prices as vendors compete for cable operators business. Consequently, our
future success may depend on our ability to compete effectively in the video marketplace by
developing, marketing and selling products that are certified and qualified to industry standards
in a timely fashion and in a cost effective manner. We depend on broadband providers capital spending for a substantial portion of our revenue and any
decrease or delay in capital spending would negatively impact our operating results and financial
condition Historically, almost all of our sales had been derived from sales to broadband providers and,
more specifically, cable operators, and we expect these sales to constitute a significant portion
of net sales for the foreseeable future. Demand for our products will depend on the magnitude and
timing of capital spending by broadband providers. These capital spending patterns depend on a
variety of factors including:  
    the availability of financing;
    annual budget cycles, as well as the typical reduction in upgrade projects during the
winter months;
    the status of federal, local and foreign government regulation and deregulation of the
telecommunications industry;
    overall demand for broadband services and the acceptance of new data, video and voice services;
    evolving industry standards and network architectures;
    competitive pressures (including the availability of alternative data transmission and
access technologies);
    discretionary consumer spending patterns; and
    general economic conditions. 31




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Average selling prices of broadband equipment may continue to decline, decreasing our gross margins The broadband equipment market has been characterized by erosion of product ASPs, particularly
for HAS products, which declined considerably in 2004, 2003, and 2002. This erosion may continue.
The ASPs for our products are likely to continue to decline due to competitive pricing pressures,
promotional programs and customers possessing strong negotiating positions which require price
reductions as a condition of purchase. In addition, we believe that the widespread adoption of
industry specifications, such as the DOCSIS and EuroDOCSIS specifications, is further eroding ASPs
as cable modems and other similar HAS products become commodity products. If a specification is
adopted for video technology, our DVS products may experience the same ASP erosion. Decreasing ASPs
could result in decreased revenues even if the number of units sold increases. Decreasing ASPs may
also require us to sell our products at much lower gross margin than in the past, and in fact, we
may sell products at a loss. The primary reason that our gross profits have generally declined in
recent years is the decline in product ASPs. As a result, we may experience substantial
period-to-period fluctuations in future revenue, gross margin and operating results due to ASP
erosion. Therefore, we must continue to develop and introduce on a timely basis and a cost-
effective manner new products or next-generation products with enhanced functionalities that can be
sold at higher gross margins. If we fail to do so our revenues and gross margins may decline
further. In addition, the gross margins we realize from the sale of our products are affected by the
mix of product sales between higher margin, lower volume digital video solutions (DVS) products,
and applications and lower margin, higher volume HAS products. We are attempting to increase our
gross margin by increasing the sale of our DVS products, reducing the manufacturing costs
associated with the HAS products, and ceasing investment in our CMTS product line. However, there
are no assurances that we will succeed. For 2005, we expect that sales of our low-margin HAS
products will continue to represent a significant portion of our revenues. If we do not generate a
greater percentage of total revenues from our DVS product revenues, we will not succeed in greatly
improving our gross margin. We must achieve cost reductions or increase revenues to attain profitability In prior years, we experienced revenue declines, which were, in large part, due to declining
product ASPs due to our transition from a proprietary platform to the DOCSIS standards platform. In
order to achieve profitability, we must significantly increase our revenues, reduce the cost of our
products, and maintain or reduce our operating expenses. Although we have implemented expense reduction and restructuring plans in the past, including
the latest restructurings in the fourth quarter of 2004, that have focused on cost reductions and
operating efficiencies, we still operate at a loss. A large portion of our expenses, including
rent, and operating lease expenditures, is fixed and difficult to reduce or change. Accordingly, if
our revenue does not meet our expectations, we may not be able to adjust our expenses quickly
enough to compensate for the shortfall in revenue, which, in turn, could materially and adversely
impact our business, financial condition and results of operations. As product ASPs decline, we need to reduce the cost of our products through design and
engineering changes. We may not be successful in redesigning our products, and, even if we are
successful, our efforts may be delayed or our redesigned products may contain significant errors
and product defects. In addition, any redesign may not result in sufficient cost reductions to
allow us to reduce significantly the prices of our products or improve our gross margins.
Reductions in our product costs may require us to use lower-priced components that are highly
integrated in future products and may require us to enter into high volume or long-term purchase or
manufacturing agreements. Volume purchase or manufacturing agreements may not be available on
acceptable terms, if at all, and we could incur significant expenses without related revenues if we
cannot use the products or services offered by such agreements. We have incurred significant vendor
cancellation charges related to volume purchase and manufacturing agreements in the past and may
incur such charges in the future. We may not be able to raise additional funds to continue operating our business 32




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Our
main source of liquidity continues to be our unrestricted cash and
cash equivalents on hand. As a result of our
history of operating losses, we expect to continue to use our unrestricted cash to fund operating
losses in the future. Our unrestricted cash, cash equivalents and short-term investments increased to $99.8
million at March 31, 2005, from $97.7 million at December 31, 2004. If our operating losses are
more severe than expected or continue longer than expected, we may find it necessary to seek other
sources of financing to support our capital needs and provide available funds for working capital.
Furthermore, as of March 31, 2005, we had $65.1 million of notes outstanding that mature in August
2007 and may need to seek additional financing to repay the notes at maturity. There may be few sources of financing available to us. Commercial bank financing may not be
available to us on acceptable terms. Accordingly, any plan to raise additional capital, if
available to us, would likely involve an equity-based or equity-linked financing, such as the
issuance of convertible debt, common stock or preferred stock, which would be dilutive to our
stockholders. On October 7, 2003, we filed a registration statement on Form S-3 with the SEC. This
shelf registration statement, which was declared effective by the SEC on November 4, 2003, will
allow us to issue various types of securities, including common stock, preferred stock, debt
securities and warrants to purchase common stock, from time to time up to an aggregate of $125.0
million, subject to market conditions and our capital needs. However, we may not be able to sell
securities on terms acceptable to us. If we are unable to procure additional working capital, as
necessary, we may be unable to continue operations. We may dispose of or discontinue existing product lines, which may adversely impact our future
results On an ongoing basis, we evaluate our various product offerings in order to determine whether
any should be discontinued or, to the extent possible, divested. Moreover, the worldwide downturn
in the telecommunications industry led us to reassess our business strategy, which in turn caused
us to discontinue investment in certain product lines. We have ceased investment in the telecom and
satellite businesses and largely sold or discontinued the various businesses we acquired in 1999
and 2000. In October 2004, we also announced our decision to cease investment in the CMTS product
line. In March 2005, we sold to ATI Technologies Inc. certain of our cable modem semiconductor
assets. We cannot guarantee that we have correctly forecasted, or will correctly forecast in the
future, the right product lines to dispose or discontinue or that our decision to dispose of or
discontinue various investments and product lines is prudent if market conditions change. In
addition, there are no assurances that the discontinuance of various product lines will reduce our
operating expenses or will not cause us to incur material charges associated with such decision.
Furthermore, the discontinuance of existing product lines entails various risks, including the
risks that we will not be able to find a buyer for a product line or the purchase price obtained
will not be equal to the book value of the assets for the product line. Other risks include
managing the expectations of, and maintaining good relations with, our customers who previously
purchased products from our disposed or discontinued product lines, which could prevent us from
selling other products to them in the future. We may also incur other liabilities and costs
associated with our disposal or discontinuance of product lines. We may be unable to provide adequate customer support Our ability to achieve our planned sales growth and retain current and future customers will
depend in part upon the quality of our customer support operations. Our customers generally require
significant support and training with respect to our products, particularly in the initial
deployment and implementation stages. Spikes in demand of our support services may cause us to be
unable to serve our customers adequately. We may not have sufficient personnel to provide the
levels of support that our customers may require during initial product deployment or on an ongoing
basis especially during peak periods. Our inability to provide sufficient support to our customers
could delay or prevent the successful deployment of our products. In addition, our failure to
provide adequate support could harm our reputation and
relationships with our customers and could prevent us from selling products to existing
customers or gaining new customers. 33




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Furthermore, we may experience transitional issues relating to customer support in connection
with our decision to dispose of or discontinue various investments and product lines. We may incur
liability associated with customers dissatisfaction with the level of customer support maintained
for discontinued product lines. We may have financial exposure to litigation We and/or our directors and officers are defendants in a number of lawsuits, including
securities litigation lawsuits and the lawsuit with Adelphia discussed above (See Part II Item 1 
Legal Proceedings for more information regarding our litigation). As a result, we may have
financial exposure to litigation as a defendant and because we are obligated to indemnify our
officers and members of our board of directors for certain actions taken by our officers and
directors on our behalf. In order to limit financial exposure arising from litigation and/or our obligation to
indemnify our officers and directors, we have historically purchased directors and officers
insurance (D&O Insurance). There can be no assurance that D&O Insurance will be available to us in
the future or, if D&O Insurance is available, that it will not be prohibitively expensive.
Additionally, some insurance underwriters who offered D&O Insurance in the past have been placed
into liquidation or may be, at some future point, placed into liquidation. If there is no insurance coverage for the litigation or, even if there is insurance coverage,
if a carrier is subsequently liquidated or placed into liquidation, we will be responsible for the
attorney fees and costs resulting from the litigation. The incurrence of significant fees and
expenses in connection with the litigation could have a material adverse effect on our results of
operations. The sales cycle for certain of our products is lengthy, which makes forecasting of our customer
orders and revenues difficult The sales cycle for certain of our products is lengthy, often lasting nine months to more than
a year. Our customers generally conduct significant technical evaluations, including customer
trials, of our products as well as competing products prior to making a purchasing decision. In
addition, purchasing decisions may also be delayed because of a customers internal budget approval
processes. Because of the lengthy sales cycle and the size of customer orders, if orders forecasted
for a specific customer for a particular period do not occur in that period, our revenues and
operating results for that particular quarter could suffer. Moreover, a portion of our expenses
related to an anticipated order is fixed and difficult to reduce or change, which may further
impact our revenues and operating results for a particular period. We need to develop additional distribution channels to market and sell our products The vast majority of our data and voice product sales have traditionally been to large cable
operators. Our DVS products have been traditionally sold to large cable operators and satellite
operators with recent, limited sales to television broadcasters. Although we intend to establish
strategic relationships with leading distributors worldwide to new customers, we may not succeed in
establishing these relationships. Even if we do establish these relationships, the distributors may
not succeed in marketing our products to their customers. Some of our competitors have established
long-standing relationships with these cable operators that may limit our and our distributors
ability to sell our products to those customers. Even if we were to sell our products to those
customers, it would likely not be based on long-term commitments, and those customers would be able
to terminate their relationships with us at any time without significant penalties. We may fail to accurately forecast customer demand for our products The nature of the broadband industry makes it difficult for us to accurately forecast demand
for our products. Our inability to forecast accurately the actual demand for our products may
result in too much or too little supply of products or an over/under capacity of manufacturing or
testing resources at any given point in time. The existence of any one or more of these situations
could have a negative impact on our 34




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business, operating results or financial condition. We have
incurred significant vendor cancellation charges related to volume purchase and manufacturing
agreements in the past and may incur such charges in the future. We had purchase obligations of
approximately $24.1 million as of March 31, 2005, primarily to purchase minimum quantities of
materials and components used to manufacture our products. We may be obligated to fulfill these
purchase obligations even if demand for our products is lower than we anticipate. We may not be able to manage expenses and inventory risks associated with meeting the demand of our
customers From time to time, we receive indications from our customers as to their future plans and
requirements to ensure that we will be prepared to meet their demand for our products. If actual
orders differ materially from these indications, our ability to manage inventory and expenses may
be affected. In addition, if we fail to meet customers supply expectations, we may lose business
from such customers. If we enter into purchase commitments to acquire materials, or expend
resources to manufacture products and such products are not purchased by our customers, our
business and operating results could suffer. We are dependent on key third-party suppliers and any failure by them to deliver components could
limit our ability to satisfy customer demand We manufacture all of our products using components or subassemblies procured from third-party
suppliers, including semiconductors. Some of these components are available from a sole source and
others are available from limited sources. A majority of our sales are from products containing one
or more components that are available only from sole source suppliers. For example, our video
equipment is single sourced from a manufacturer in San Jose, California. Our modems are sourced
from a manufacturer in China. Additionally, some of our components are custom parts that are
produced to our specifications, and it may be difficult to move the manufacturing of such
components from one vendor to another vendor. Any interruption in the operations of our vendors of sole source or custom product parts could
adversely affect our ability to meet our scheduled product deliveries to customers. If we are
unable to obtain a sufficient supply of components, including semiconductors, from our current
sources, we could experience difficulties in obtaining alternative sources or in altering product
designs to use alternative components. Resulting delays or reductions in product shipments could
damage customer relationships and expose us to potential damages that may arise from our inability
to supply our customers with products. Further, a significant increase in the price of one or more
of these components, such as our semiconductor components, could harm our gross margin or operating
results. Additionally, we attempt to limit this risk by maintaining safety stocks of these
components, subassemblies and modules. As a result of this investment in inventories, we have in
the past and in the future may be subject to risk of excess and obsolete inventories, which could
harm our business. In this regard, our gross margins and operating results could be adversely
affected by excess and obsolete inventory. We may be unable to migrate to new semiconductor process technologies successfully or on a timely
basis Our future success will depend in part upon our ability to develop products that utilize new
semiconductor process technologies. These technologies change rapidly and require us to spend
significant amounts on research and development. We continuously evaluate the benefits of
redesigning our integrated circuits using smaller geometry process technologies to improve
performance and reduce costs. The transition of our products to integrated circuits with
increasingly smaller geometries will be important to our competitive position. Other companies have
experienced difficulty in migrating to new semiconductor processes and, consequently, have suffered reduced yields, delays in product deliveries and
increased expense levels. Moreover, we depend on our relationship with our third-party
manufacturers to migrate to smaller geometry processes successfully. Our ability to directly control product delivery schedules and product quality is dependent on
third-party contract manufacturers 35




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Most of our products are assembled and tested by contract manufacturers using testing
equipment that we provide. As a result of our dependence on these contract manufacturers for the
assembly and testing of our products, we do not directly control product delivery schedules or
product quality. Any product shortages or quality assurance problems could increase the costs of
manufacturing, assembling or testing our products. In addition, as manufacturing volume increases,
we will need to procure and assemble additional testing equipment and provide it to our contract
manufacturers. The production and assembly of testing equipment typically requires significant lead
times. We could experience significant delays in the shipment of our products if we are unable to
provide this testing equipment to our contract manufacturers in a timely manner. We are dependent upon international sales and there are many risks associated with international
operations We expect sales to customers outside of the United States to continue to represent a
significant percentage of our revenues for the foreseeable future. For the years ended December 31,
2004, 2003 and 2002, approximately 45%, 44% and 68%, respectively, of our net revenues were from
customers outside of the U.S. International sales are subject to a number of risks, including the
following:  
    changes in foreign government regulations and communications standards;
    import and export license requirements, tariffs and taxes;
    trade barriers and trade disputes;
    difficulty in protecting intellectual property;
    difficulty in collecting accounts receivable;
    currency fluctuations;
    the burden of complying with a wide variety of foreign laws, treaties and technical standards;
    difficulty in staffing and managing foreign operations; and
    political and economic instability. If our customers are affected by currency devaluations or general economic downturns their
ability to purchase our products could be reduced significantly. Payment cycles for international
customers typically are longer than those for customers in North America. Our international operations are subject to certain risks common to foreign operations in
general, such as governmental regulations and import restrictions. In addition, there are social,
political, labor and economic conditions in specific countries or regions as well as difficulties
in staffing and managing foreign operations, and potential adverse foreign tax consequences, among
other factors that could also have an impact on our business and results of operations outside of
the United States. Furthermore, foreign countries may decide to prohibit, terminate or delay the construction of
new broadband infrastructures for a variety of reasons. These reasons include environmental issues,
economic downturns and availability of favorable pricing for other communications services or the
availability and cost of related equipment. Any such action by foreign countries would reduce the
market for our products. Like other companies operating or selling internationally, we are subject to the Foreign
Corrupt Practices Act (FCPA) and other laws which prohibit improper payments or offers of payments
to foreign governments and their officials and political parties by U.S. and other business
entities for the purpose of obtaining or retaining business. We make sales in countries known to
experience corruption. Our sales activities in such countries create the risk of an unauthorized
payments or offers of payments by one of our employees, consultants, sales agents or distributors
which could be in violation of various laws including the FCPA, even though such parties are not
always subject to our control. We have attempted to implement safeguards to prevent losses from
such practices and to discourage such practices by our 36




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employees, consultants, sales agents and
distributors. However, our safeguards may prove to be less than effective and our employees,
consultants, sales agents or distributors may engage in conduct for which we might be held
responsible. Violations of the FCPA may result in severe criminal or civil sanctions, and we may be
subject to other liabilities, which could negatively affect our business, financial condition and
results of operations. The deployment process for our equipment may be lengthy and may delay the receipt of new orders and
cause fluctuations in our revenues The timing of deployment of our equipment can be subject to a number of other risks, including
the availability of skilled engineering and technical personnel, the availability of other
equipment such as fiber optic cable, and the need for local zoning and licensing approvals. We
believe that changes in our customers deployment plans have delayed, and may in the future delay
the receipt of new orders. Since the majority of our sales have been to relatively few customers, a
delay in equipment deployment with any one customer has in the past had, and could in the future,
have a material adverse effect on our sales for a particular quarter. Our industry is highly competitive with many larger and more established competitors The market for our products is extremely competitive and is characterized by rapid
technological change. Our direct competitors include Ambit Microsystems Corporation, Cisco Systems,
BigBand Networks, Motorola, Scientific-Atlanta and Toshiba. Additionally, we face competition from
early stage companies with access to significant financial backing that improve existing
technologies or develop new technologies. The principal competitive factors in our market include
the following:  
    product performance, features and reliability;
    price;
    size and stability of operations;
    breadth of product line;
    sales and distribution capabilities;
    technical support and service;
    relationships with providers of service providers; and
    compliance with industry standards. Some of these factors are outside of our control. Conditions in the market could change
rapidly and significantly as a result of technological advancements. The development and market
acceptance of alternative technologies could decrease the demand for our products or render them
obsolete. Our competitors may introduce products that are less costly, provide superior performance
or achieve greater market acceptance than our products. Many of our current and potential competitors have greater financial, technical, marketing,
distribution, customer support and other resources, as well as better name recognition and access
to customers than we do. The widespread adoption of DOCSIS and other industry standards has and is
likely to continue to cause increased price competition. We believe that the adoption of these
standards have resulted in and are likely to continue to result in lower ASPs for our products. Any
increased price competition or reduction in sales of our products, particularly our higher margin
head-end products, has 37




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resulted and will continue to result in decreased revenue and downward
pressure on our gross margin. These competitive pressures have and are likely to continue to have
an adverse impact on our business. Our business is subject to the risks of warranty returns, product liability and product defects Products like ours are very complex and can frequently contain undetected errors or failures,
especially when first introduced or when new versions are released. Despite testing, errors may
occur. Product errors could affect the performance or interoperability of our products, delay the
development or release of new products or new versions of products, adversely affect our reputation
and our customers willingness to buy products from us and adversely affect market acceptance or
perception of our products. Any such errors or delays in releasing new products or new versions of
products or allegations of unsatisfactory performance could cause us to lose revenue or market
share, increase our service costs, cause us to incur substantial costs in redesigning the products,
subject us to liability for damages and divert our resources from other tasks, any one of which
could materially and adversely affect our business, results of operations and financial condition.
Although we have limitation of liability provisions in our standard terms and conditions of sale,
they may not be effective as a result of federal, state or local laws or ordinances or unfavorable
judicial decisions in the United States or other countries. The sale and support of our products
also entails the risk of product liability claims. We maintain insurance to protect against certain
claims associated with the use of our products, but our insurance coverage may not adequately cover
any claim asserted against us. In addition, even claims that ultimately are unsuccessful could
result in our expenditure of funds in litigation and divert managements time and other resources. We may be unable to adequately protect or enforce our intellectual property rights We rely on a combination of patent, trade secret, copyright and trademark laws and contractual
restrictions to establish and protect proprietary rights in our products. Even though we seek to
establish and protect proprietary rights in our products, there are risks. There are no assurances
that any patent, trademark, copyright or other intellectual property rights owned by us will not be
invalidated, circumvented or challenged, that such intellectual property rights will provide
competitive advantages to us or that any of our pending or future patent applications will be
issued with the scope of the claims sought by us, if at all. There are no assurances that others
will not develop technologies that are similar or superior to our technology, duplicate our
technology or design around the patents that we own. In addition, effective patent, copyright and
trade secret protection may be unavailable or limited in certain foreign countries in which we do
business or may do business in the future. Our pending patent applications may not be granted. Even if they are granted, the claims
covered by any patent may be reduced from those included in our applications. Any patent might be
subject to challenge in court and, whether or not challenged, might not be broad enough to prevent
third parties from developing equivalent technologies or products without a license from us. We believe that the future success of our business will depend on our ability to translate the
technological expertise and innovation of our employees into new and enhanced products. We have
entered into confidentiality and invention assignment agreements with our employees, and we enter
into non-disclosure agreements with many of our suppliers, distributors and appropriate customers
so as to limit access to and disclosure of our proprietary information. These contractual
arrangements, as well as statutory protections, may not prove sufficient to prevent
misappropriation of our trade secrets or technology or deter independent third-party development of
similar technologies. In addition, the laws of some foreign countries may not protect our
intellectual property rights to the same extent as do the laws of the United States. We may, in the
future, take legal action to enforce our patents and other intellectual property rights, to
protect our trade secrets, to determine the validity and scope of the
proprietary rights of others, or to defend against claims of infringement or invalidity. Such
litigation could result in substantial costs and diversion of resources and could negatively affect
our business, operating results, financial position and liquidity. CableLabs DOCSIS 2.0 specification includes two advanced physical layer technologies, S-CDMA
and A-TDMA. In connection with the development of the DOCSIS 2.0 specification by CableLabs, we 38




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entered into an agreement with CableLabs, on a royalty-free basis, whereby we licensed to CableLabs
many of our intellectual property rights to the extent that such rights may be asserted against a
party desiring to design, manufacture or sell DOCSIS-based products, including DOCSIS 2.0-based
products. This license agreement grants to CableLabs the right to sublicense our intellectual
property, including our intellectual property rights in our S-CDMA patents, to manufacturers that
compete with us in the marketplace for DOCSIS based products. We pursue the registration of our trademarks in the United States and have applications
pending to register several of our trademarks throughout the world. However, the laws of certain
foreign countries might not protect our products or intellectual property rights to the same extent
as the laws of the United States. Effective trademark, copyright, trade secret and patent
protection may not be available in every country in which our products may be manufactured,
marketed or sold. Third party claims of infringement or other claims against us could adversely affect our ability to
market our products, require us to redesign our products or seek licenses from third parties, and
seriously harm our operating results and disrupt our business As is typical in our industry, we have been and may from time to time be notified of claims
asserting that we are infringing intellectual property rights owned by third parties. We also have
in the past agreed to, and may from time to time in the future agree to, indemnify customers of our
technology or products for claims against such customers by a third party based on claims that
our technology or products infringe patents of that third party. We further believe that companies
may be increasingly subject to infringement claims as distressed companies and individuals attempt
to generate cash by enforcing their patent portfolio against a wide range of products. These types
of claims, meritorious or not, can result in costly and time-consuming litigation; divert
managements attention and other resources; require us to enter into royalty arrangements; subject
us to damages or injunctions restricting the sale of our products, require us to indemnify our
customers for the use of the allegedly infringing products; require us to refund payment of
allegedly infringing products to our customers or to forgo future payments; require us to redesign
certain of our products; or damage our reputation. Our failure to obtain a license for key
intellectual property rights from a third party for technology used by us could cause us to incur
substantial liabilities and to suspend the manufacturing of products utilizing the technology.
Alternatively, we could be required to expend significant resources to develop non-infringing
technology with no assurances that we would be successful in such endeavors. The occurrence of any
of the above events could materially and adversely affect our business, results of operations and
financial condition. Our indebtedness could adversely affect our financial condition and we may incur substantially more
debt As of March 31, 2005, we had approximately $68.6 million of long-term obligations of which
$65.1 million is long-term debt associated with our Notes. This level of indebtedness may adversely
affect our stockholders by:  
    making it more difficult for us to satisfy our obligations with respect to our indebtedness;
    increasing our vulnerability to general adverse economic and industry conditions;
    limiting our ability to obtain additional financing;
    requiring the dedication of a substantial portion of our cash flow from operations to
the payment of principal of, and interest on, our indebtedness, thereby reducing the
availability of our cash flow to fund our growth strategy, working capital, capital
expenditures and other general corporate purposes;
    limiting our flexibility in planning for, or reacting to, changes in our business and
the industry; and
    placing us at a competitive disadvantage relative to our competitors with less debt. 39




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We may incur substantial additional debt in the future. If new debt is added to our current
levels, the related risks described above could intensify. We need to develop and introduce new and enhanced products in a timely manner to remain competitive The markets in which we operate are characterized by rapidly changing technologies, evolving
industry standards, frequent new product introductions and relatively short product life. The
pursuit of necessary technological advances and the development of new products require substantial
time and expense. For example, we acquired ten businesses during the period between 1999 and 2000.
Due to various economic conditions, none of the products from our acquired businesses have achieved
the level of market acceptance that was forecasted at the time of their acquisitions. Additionally,
certain product groups have not achieved the level of technological development needed to be
marketable or to expand the market. As a result, we recorded an aggregate of approximately $576.8
million related to impairment charges and write-down of in- process research and development
related to the acquired technologies, both of which negatively impacted our operating results in
2001 and 2002. To compete successfully in the markets in which we operate, we must design, develop,
manufacture and sell new or enhanced products that provide increasingly higher levels of
performance and reliability. However, we may not be able to successfully develop or introduce these
products, if our products are not:  
    cost effective;
    brought to market in a timely manner;
    in accordance with evolving industry standards and architecture; or
    fail to achieve market acceptance. There is no assurance that the technologies we are currently developing or intend to develop
will achieve feasibility or that even if we are successful, the developed product will be accepted
by the market. We may not be able to recover the costs of existing and future product developments
and our failure to do so may materially and adversely impact our business, financial condition and
results of operations. We are exposed to the credit risk of our customers and to credit exposures in weakened markets,
which could result in material losses Most of our sales are on an open credit basis, with payment terms of 30 to 60 days typically
in the United States, and because of local customs or conditions, longer in some markets outside
the United States. Beyond our open credit arrangements, we have also experienced a request for
customer financing and facilitation of leasing arrangements, which we have not provided to date and
do not expect to provide in the future. We expect demand for enhanced open credit terms, for
example, longer payment terms, customer financing and leasing arrangements to continue and believe
that such arrangements are a competitive factor in obtaining business. Our decision not to provide
these types of financing arrangements may adversely affect our ability to sell products, and
therefore, our revenue, operations and business. Because of the current condition in the global economy, our exposure to credit risks relating
to sales on an open-credit basis has increased. Although we monitor and attempt to mitigate the
associated risk,
there can be no assurance that our efforts will be effective in reducing credit risk.
Additionally, there have been significant insolvencies and bankruptcies among our customers, which
have and may continue to cause us to incur economic and financial losses. There can be no assurance
that additional losses would not be incurred and that such losses would not be material. Although
these losses have generally not been material to date, future losses, if incurred, could harm our
business and have a material adverse effect on our operating results and financial condition. 40




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We have and we may seek to expand our business through acquisitions which could disrupt our
business operations and harm our operating results In order to expand our business, we may make strategic acquisitions of other companies or
certain assets. We plan to continue to evaluate opportunities for strategic acquisitions from time
to time, and may make an acquisition at some future point. However, the current volatility in the
stock market and the current price of our common stock may adversely affect our ability to make
such acquisitions. Any acquisition that we make involves substantial risks, including the
following:  
    difficulties in integrating the operations, technologies, products and personnel of an
acquired company;
    diversion of managements attention from normal daily operations of the business;
    potential difficulties in completing projects associated with in-process research and development;
    difficulties in entering markets in which we have no or limited direct prior experience
and where competitors in such markets have stronger market positions;
    initial dependence on unfamiliar supply chains or relatively small supply partners;
    insufficient revenues to offset increased expenses associated with acquisitions; and
    the potential loss of key employees of the acquired companies. Acquisitions may also cause us to:  
    issue common stock that would dilute our current stockholders percentage ownership;
    assume liabilities;
    record goodwill and non-amortizable intangible assets that will be subject to
impairment testing and potential periodic impairment charges;
    incur amortization expenses related to certain intangible assets;
    incur large and immediate write-offs; or
    become subject to litigation. For example, we made ten acquisitions during the period between 1999 and 2000. Due to various
economic conditions, none of the products from our acquired businesses have achieved the level of
market acceptance that was forecasted at the time of their acquisitions. As a result, we recorded
an aggregate of approximately $576.8 million related to impairment charges and write-down of
in-process research and development related to the acquired technologies, both of which negatively
impacted our operating results in 2001 and 2002. Mergers and acquisitions of high-technology companies are inherently risky, and no assurance
can be given that our future acquisitions will be successful and will not materially adversely
affect our business, operating results or financial condition. Failure to manage and successfully
integrate acquisitions we make could harm our business and operating results in a material way.
Even when an acquired company has already developed and marketed products, there can be no
assurance that product enhancements will be made in a timely fashion or that all pre-acquisition
due diligence will have identified all possible issues that might arise with respect to such
products. Our products are subject to safety approvals and certifications 41




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In the United States, our products are required to meet certain safety requirements. For
example, we are required to have our products certified by Underwriters Laboratory in order to meet
federal requirements relating to electrical appliances to be used inside the home. Outside the
United States, our products are subject to the regulatory requirements of each country in which the
products are manufactured or sold. These requirements are likely to vary widely. We may be unable
to obtain on a timely basis or at all the regulatory approvals that may be required for the
manufacture, marketing and sale of our products. Compliance with current and future environmental regulations may be costly which could impact our
future earnings. We may be subject to environmental and other regulations due to our production and marketing
of products in certain states and countries. In addition, we could face significant costs and
liabilities in connection with product take-back legislation, which enables customers to return a
product at the end of its useful life and charges us with financial and other responsibility for
environmentally safe collection, recycling, treatment and disposal. We also face increasing
complexity in our product design and procurement operations as we adjust to new and upcoming
requirements relating to the materials composition of our products, including the restrictions on
lead and certain other substances in electronics that will apply to specified electronics products
put on the market in the European Union as of July 1, 2006 (Restriction of Hazardous Substances in
Electrical and Electronic Equipment Directive (EU RoHS)). The European Union has also finalized
the Waste Electrical and Electronic Equipment Directive, which makes producers of electrical goods
financially responsible for specified collection, recycling, treatment and disposal of past and
future covered products. The deadline for enacting and implementing this directive by individual
European Union governments was August 13, 2004 (such legislation, together with the directive, the
WEEE Legislation), although extensions were granted in some countries. Producers are to be
financially responsible under the WEEE Legislation beginning in August 2005. Other countries,
such as the United States, China and Japan, have enacted or may enact laws or regulations similar
to the EU RoHS or WEEE legislation. Other environmental regulations may require us to reengineer
our products to utilize components which are more environmentally compatible. Such reengineering
and component substitution may result in additional costs to us. Although we currently do not
anticipate any material adverse effects based on the nature of our operations and the effect of
such laws, there is no assurance that such existing laws or future laws will not have a material
adverse effect on us. Various export licensing requirements could materially and adversely affect our business or require
us to significantly modify our current business practices Various government export regulations may apply to the encryption or other features of our
products. We may have to make certain filings with the government in order to obtain permission to
export certain of our products. In the past, we may have inadvertently failed to file certain
export applications and notices, and we may have to make certain filings and request permission to
continue exportation of any affected products without interruption while these applications are
pending. If we do have to make such filings, there are no assurances that we will obtain permission
to continue exporting the affected products or that we will obtain any required export approvals
now or in the future. If we do not receive the required export approvals, we may be unable to ship
those products to certain customers located outside of the United States. In addition, we may be
subject to fines or other penalties due to the failure to file certain export applications and
notices. Compliance with changing laws and regulations relating to corporate governance and public
disclosure has resulted, and will continue to result, in the incurrence of additional expenses
associated with being a public company New and changing laws and regulations, including the Sarbanes-Oxley Act of 2002, new SEC
regulations and NASDAQ National Market Rules, impose stricter corporate governance requirements,
greater disclosure obligations, and greater focus on disclosure and internal controls. These new
laws and
regulations have had the effect of increasing the complexity and cost of our Companys
corporate governance compliance, diverting the time and attention of our management from
revenue-generating 42




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activities to compliance activities, and increasing the risk of personal
liability for our board members and executive officers involved in our Companys corporate
governance process. Our efforts to comply with evolving laws and regulations have resulted, and
will continue to result, in increased general and administrative expenses, and increased
professional and independent auditor fees. In addition, it has become more difficult and expensive
for us to obtain director and officer liability insurance. In order to meet the new corporate governance and financial disclosure obligations, we have
been taking, and will continue to take, steps to improve our controls and procedures, including
disclosure and internal controls, and related corporate governance policies and procedures to
address compliance issues and correct any deficiencies that we may discover. For example, pursuant
to the requirements of Section 404 of Sarbanes-Oxley, we undertook a comprehensive and costly
evaluation of our internal controls and disclosure controls and procedures. Based on this
evaluation, our management determined that our internal controls over financial reporting and our
disclosure controls and procedures as of December 31, 2004 were
ineffective. Furthermore, we have determined that our disclosure
controls and procedures as of March 31, 2005 continue to be
ineffective. In response to these
deficiencies, our management has commenced the necessary processes and procedures to remediate the
deficiencies in our disclosure and internal control by establishing, implementing and testing
additional controls. Our efforts to correct the deficiencies in our disclosure and internal
controls have required, and will continue to require, the commitment of significant financial and
managerial resources. In addition, we anticipate the costs associated with the testing and
evaluation of our internal controls will be significant and material in fiscal year 2005 and may
continue to be material in future fiscal years as these controls are maintained and continually
evaluated and tested. Furthermore, changes in our operations and the growth of our business may require us to modify
and expand our disclosure controls and procedures, internal controls and related corporate
governance policies. In addition, the new and changed laws and regulations are subject to varying
interpretations in many cases due to their lack of specificity, and as a result, their application
in practice may evolve over time as new guidance is provided by regulatory and governing bodies. If
our efforts to comply with new or changed laws and regulations differ from the conduct intended by
regulatory or governing bodies due to ambiguities or varying interpretations of the law, we could
be subject to regulatory sanctions, our reputation may be harmed and our stock price may be
adversely affected. Newly adopted accounting regulations that require companies to expense stock options will result in
a decrease in our earnings and our stock price may decline. The Financial Accounting Standards Board recently adopted the previously proposed regulations
that will eliminate the ability to account for share-based compensation transactions using the
intrinsic method that we currently use and generally would require that such transactions be
accounted for using a fair-value-based method and recognized as an expense in our consolidated
statement of operations. We will be required to expense stock options effective in periods after
January 1, 2006. Currently, we generally only disclose such expenses on a pro forma basis in the
notes to our consolidated financial statements in accordance with accounting principles generally
accepted in the United States. The adoption of this new accounting regulation will have a
significant impact on our results of operations and our stock price could decline accordingly. Exchange rate fluctuations could cause a decline in our financial condition and results of
operations While we generally invoice our foreign sales in U.S. dollars, we invoice some of our sales in
Europe in Euros and other sales in the United Kingdom, Belgium, Canada, Japan, Hong Kong, Korea and
China in local currencies. Since we have also elected to take payment from our customers in local
currencies and may elect to take payment in other foreign currencies in the future, we are exposed
to losses as the result of foreign currency fluctuations. We currently do not engage in foreign
currency hedging transactions. We may in the future choose to limit our exposure by the purchase of
forward foreign exchange contracts or through similar hedging strategies. No currency hedging
strategy can fully protect against exchange-related losses. In addition, if the relative value of
the U.S. dollar in comparison to the currency of our foreign
customers should increase, the resulting effective price increase of our products to those
foreign customers could result in decreased sales. 43




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Furthermore, foreign countries may decide to prohibit, terminate or delay the construction of
new broadband infrastructures for a variety of reasons. These reasons include environmental issues,
economic downturns and availability of favorable pricing for other communications services or the
availability and cost of related equipment. Any such action by foreign countries would reduce the
market for our products. Our stock price has been and is likely to continue to be highly volatile The trading price of our common stock has been and is likely to continue to be highly
volatile. Our stock price could be subject to extreme fluctuations in response to a variety of
factors, including the following:  
    actual or anticipated variations in quarterly operating results;
    announcements of technological innovations;
    new products or services offered by us or our competitors;
    changes in financial estimates by securities analysts;
    conditions or trends in the broadband services industry;
    changes in the economic performance and/or market valuations of Internet, online
service or broadband service industries;
    our announcement of significant acquisitions, strategic partnerships, joint ventures or
capital commitments;
    adoption of industry standards and the inclusion or compatibility of our technology
with such standards;
    adverse or unfavorable publicity regarding us or our products;
    additions or departures of key personnel;
    sales of common stock; and
    other events or factors that may be beyond our control. In addition, the stock markets in general, and the Nasdaq National Market and the stock price
of broadband services and technology companies in particular, have experienced extreme price and
volume volatility. This volatility and decline has affected many companies irrespective of or
disproportionately to the operating performance of these companies. Additionally, industry factors
may materially adversely affect the market price of our common stock, regardless of our actual
operating performance. We have adopted a stockholder rights plan, which, together with provisions in our charter documents
and Delaware law, may delay or prevent an acquisition of us, which could decrease the value of our
stock We adopted a stockholder rights plan pursuant to which we distributed one right for each
outstanding share of common stock held by stockholders of record as of February 20, 2001. Because
the rights may substantially dilute the stock ownership of a person or group attempting a take-over
of us, even if such a change in control is beneficial to our stockholders, without the approval of
our board of directors, the plan could make it more difficult for a third party to acquire us, or a
significant percentage of our outstanding
capital stock, without first negotiating with our board of directors. Additionally, provisions
of our Certificate of Incorporation and our Bylaws could make it more difficult for a third party
to acquire control of us in a transaction not approved by our Board of Directors, and we are
subject to the anti-takeover 44




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provisions of Section 203 of the Delaware General Corporation Law,
which could also have the effect of delaying or preventing our acquisition by a third party. We rely on complex information technology systems and networks to operate our business. Any
significant system or network disruption could have a material adverse impact on our operations,
sales and operating results We rely on the efficient and uninterrupted operation of complex information technology systems
and networks. All information technology systems are potentially vulnerable to damage or
interruption from a variety of sources, including but not limited to computer viruses, security
breach, energy blackouts, natural disasters, terrorism, war and telecommunication failures. There
also may be system or network disruptions if new or upgraded business management systems are
defective or are not installed properly. We have implemented various measures to manage our risks
related to system and network disruptions, but a system failure or security breach could negatively
impact our operations and financial results. In addition, we may incur additional costs to remedy
the damages caused by these disruptions or security breaches. We are vulnerable to earthquakes, disruptions to our power supply, labor issues and other
unexpected events Our corporate headquarters, as well as the majority of our research and development activities
and some manufacturing operations are located in California, an area known for seismic activity. In
addition, the operations of some of our key suppliers and manufacturers are also located in this
area and in other areas known for seismic activity, such as Taiwan. An earthquake, or other
significant natural disaster, could result in an interruption in our business or the operations of
one or more of our key suppliers. Our California operations may also be subject to disruptions in
power supply, such as those that occurred in 2001. Our business may also be impacted by labor
issues related to our operations and/or those of our suppliers, service providers, or customers.
Such an interruption could harm our operating results. We may not carry sufficient business
interruption insurance to compensate for any losses that we may sustain as a result of any natural
disasters or other unexpected events. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Risk. Our exposure to market risk for changes in interest rates relates primarily to our investment
portfolio. The primary objective of our investment activities is to preserve principal while
maximizing yields without significantly increasing risk. This is accomplished by investing in
widely diversified short-term investments, consisting primarily of investment grade securities,
substantially all of which mature within the next twenty-four months. A hypothetical 50 basis point
increase in interest rates would result in an approximate $346,000 decline (less than 1%) in the
fair value of our available-for-sale securities. Foreign Currency Risk. A substantial majority of our revenue, expense and capital purchasing activity are transacted
in U.S. dollars. However, we do enter into transactions from Belgium, United Kingdom, Hong Kong and
Canada denominated in local currencies. A hypothetical adverse change of 10% in exchange rates
would result in a decline in income before taxes of approximately $199,000. All of the potential changes noted above are based on sensitivity analyses performed on our
financial positions at March 31, 2005. Actual results may differ materially. 
 ITEM 4. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures. 45




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Under
the supervision and with the participation of our senior management,
including our CEO  and CFO,  we conducted an evaluation of the
effectiveness of the design and operation of our disclosure controls
and procedures as of March 31, 2005. Based on that evaluation, as of
the date of the evaluation, our management, including our CEO and
CFO, concluded that our disclosure controls and procedures were not
effective as of March 31, 2005 because of the material weakness
described below. We have already implemented, and will continue to
implement, corrective actions with respect to this material weakness,
as further described below. As
disclosed in our 2004 Annual Report on Form 10-K, we identified two
material weaknesses in the evaluation of our disclosure controls and
procedures as of December 31, 2004. The first material weakness
related to the identification, capture, and timely communication of
financially significant information between certain parts of our
organization and the finance department. The second material weakness
related to our procedures and controls over the preparation and
review of the Annual Report on Form 10-K. As part of the evaluation of our disclosure controls and procedures as of March 31, 2005, we
determined that we have remediated the material weakness related to our procedures and controls
over the preparation and review of our consolidated financial statements and accompanying footnote
disclosures contained in this Quarterly Report on Form 10-Q. The insufficient controls, which were
originally identified during the preparation of the Annual Report on Form 10-K, included a lack of
sufficient personnel with technical accounting expertise in our finance department and inadequate
review and approval procedures to prepare external financial statements in accordance with GAAP. As
a result of the new procedures and controls we implemented for the preparation and review of this
Quarterly Report on Form 10-Q and the remediation steps described below, we believe we have
remediated this material weakness. Senior management will continue to monitor the technical
accounting expertise of finance personnel staff closely to ensure that adequate review and approval
of our financial statements is maintained. As part of the same evaluation, we determined, however, that we have not completed
implementation of the changes we believe are required to remediate the previously reported material
weakness related to the inadequacy of communication between our senior management and the finance
department. During their review of our interim financial results for the three months ended March
31, 2005, our independent registered public accounting firm identified two significant adjustments
to our financial statements as part of their quarterly review procedures. These two adjustments
were the result of the continued lack of communication within the Company with regards to certain
severance obligations and our policy for the allowance for doubtful accounts. These two
adjustments were corrected prior to the issuance of our financial statement for the three months
ended March 31, 2005.


Remediation Steps

During
the quarter ended March 31, 2005 and through to the date of the
filing of this Form 10-Q, and in response to the material
weaknesses identified as of December 31, 2004, we implemented the
following steps to remediate the deficiencies in our disclosure
controls and procedures and material weaknesses in our internal control
over financial reporting.

(i)
    Established procedures to document the review of
press releases to account for transactions in a complete and timely manner;(ii)
    Engaged the former Assistant Controller, who has significant SEC reporting
experience, to serve as our Controller, in part to supervise our financial reporting to ensure
compliance with SEC requirements;(iii)
    Promoted our Consolidations Reporting Manager to Director of Accounting to
provide greater individual management of all accounting functions; and(iv)
    Improved our internal process of drafting and reviewing periodic reports by
implementing additional management and external legal counsel review prior to their submission to
our independent registered public accounting firm.


Moreover, we intend to implement
the following additional remediation steps to address the material weakness related to the inadequacy of communication between our senior
management and the finance department;

(i)
    Continue to monitor the communication channels between our senior management
and our finance department and take prompt action, as necessary, to further strengthen
these communication channels;(ii)
    Increase staffing in the finance department;(iii)
    Re-allocate duties to persons within the finance
organization to maximize their skills and experience;(iv)
    Implement training procedures for new employees
and/or consultants in the finance department on our disclosure procedures and controls,
our Company and our  actions in previous reporting periods; and(v)
    Take steps to ensure that our senior management has timely access to all
material financial and non-financial information concerning our business.




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Changes in internal control over financial reporting.Other than as described above, there has
been no change in our internal control over financial reporting during our most recently completed
fiscal quarter that has materially affected or is likely to materially affect our internal control
over financial reporting. 
 PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS Beginning in April 2000, several plaintiffs filed class action lawsuits in federal court
against us and certain of our officers and directors. Later that year, the cases were consolidated
in the United States District Court, Northern District of California as In re Terayon Communication
Systems, Inc. Securities Litigation. The Court then appointed lead plaintiffs who filed an amended
complaint. In 2001, the Court granted in part and denied in part defendants motion to dismiss, and
plaintiffs filed a new complaint. In 2002, the Court denied defendants motion to dismiss that
complaint, which, like the earlier complaints, alleges that the defendants violated the federal
securities laws by issuing materially false and misleading statements and failing to disclose
material information regarding our technology. On February 24, 2003, the Court certified a
plaintiff class consisting of those who purchased or otherwise acquired our securities between
November 15, 1999 and April 11, 2000. On September 8, 2003, the Court heard defendants motion to disqualify two of the lead
plaintiffs and to modify the definition of the plaintiff class. On September 10, 2003, the Court
issued an order vacating the hearing date for the parties summary judgment motions, and, on
September 22, 2003, the Court issued another order staying all discovery until further notice and
vacating the trial date, which had been November 4, 2003. On February 23, 2004, the Court issued an order disqualifying two of the lead plaintiffs. The
order also states that plaintiffs counsel must provide certain information to the Court about
counsels relationship with the disqualified lead plaintiffs, and it provides that defendants may
serve certain additional discovery. On March 24, 2004, plaintiffs submitted certain documents to
the Court in response to its order, and, on April 16, 2004, we responded to this submission. We
have also initiated discovery pursuant to the Courts February 23, 2004 order. On October 16, 2000, a lawsuit was filed against us and the individual defendants (Zaki Rakib,
Selim Rakib and Raymond Fritz) in the California Superior Court, San Luis Obispo County. This
lawsuit is titled Bertram v. Terayon Communications Systems, Inc. The factual allegations in the
Bertram complaint were similar to those in the federal class action, but the Bertram complaint
sought remedies under state law. Defendants removed the Bertram case to the United States District
Court, Central District of California, which dismissed the complaint and transferred the case to
the United States District Court, Northern District of California. That Court eventually issued an
order dismissing the case. Plaintiffs have appealed this order, and their appeal was heard on April
16, 2004. On June 9, 2004, the United States Court of Appeals for the Ninth Circuit affirmed the
order dismissing the Bertram case. The Court of Appeals opinion affirming dismissal of the Bertram case does not end the class
action. We believe that the allegations in the class action are without merit, and we intend to
contest this matter vigorously. This matter, however, could prove costly and time consuming to
defend, and there can be no assurances about the eventual outcome. In 2002, two shareholders filed derivative cases purportedly on behalf of us against certain
of our current and former directors, officers, and investors. (The defendants differed somewhat in
the two cases.)
Since the cases were filed, the investor defendants have been dismissed without prejudice, and
the lawsuits have been consolidated as Campbell v. Rakib in the California Superior Court, Santa
Clara County. We are a nominal defendant in these lawsuits, which allege claims relating to
essentially the same purportedly misleading statements that are at issue in the pending securities
class action. In the securities class action, we dispute making any misleading statements. The
derivative complaints also allege claims relating to stock sales by certain of the director and
officer defendants. 47




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We believe that there are many defects in the Campbell and OBrien derivative complaints. In January 2005, Adelphia Corporation (Adelphia) sued us in the District Court of the City and
County of Denver, Colorado. Adelphias complaint alleges, among other things, breach of contract
and misrepresentation in connection with our sale of CMTS products to Adelphia and our announcement
to cease future investment in the CMTS market. Adelphia seeks unspecified monetary damages and
declaratory relief. We filed a motion to dismiss the complaint on February 24, 2005. On March 21,
2005, Adelphia filed its response to the motion to dismiss the complaint, and on April 5, 2005, we
filed our reply in support of the motion to dismiss the complaint. On April 29, 2005, the court
denied our motion to dismiss the complaint thereby permitting the case and discovery to go forward. We have until May
19, 2005 to respond to Adelphias complaint. As we believe that Adelphias allegations are without
merit, we intend to contest this matter vigorously. This matter, however, could prove costly and
time consuming to defend, and there can be no assurances about the eventual outcome. We have received letters claiming that our technology infringes the intellectual property
rights of others. We have consulted with our patent counsel and are in the process of reviewing the
allegations made by such third parties. If these allegations were submitted to a court, the court
could find that our products infringe third party intellectual property rights. If we are found to
have infringed third party rights, we could be subject to substantial damages and/or an injunction
preventing us from conducting our business. In addition, other third parties may assert
infringement claims against us in the future. A claim of infringement, whether meritorious or not,
could be time-consuming, result in costly litigation, divert our managements resources cause
product shipment delays or require us to enter into royalty or licensing arrangements. These
royalty or licensing arrangements may not be available on terms acceptable to us, if at all. Furthermore, we have in the past agreed to, and may from time to time in the future agree to,
indemnify a customer of ours technology or products for claims against the customer by a third
party based on claims that our technology or products infringe intellectual property rights of that
third party. These types of claims, meritorious or not, can result in costly and time-consuming
litigation; divert managements attention and other resources; require us to enter into royalty
arrangements; subject us to damages or injunctions restricting the
sale of our products; require us
to indemnify our customers for the use of the allegedly infringing products; require us to refund
payment of allegedly infringing products to our customers or to forgo future payments; require us
to redesign certain of our products; or damage our reputation, any one of which could materially
and adversely affect our business, results of operations and financial condition. We may, in the future, take legal action to enforce our patents and other intellectual
property rights, to protect our trade secrets, to determine the validity and scope of the
proprietary rights of others, or to defend against claims of infringement or invalidity. Such
litigation could result in substantial costs and diversion of resources and could negatively affect
our business, operating results, financial position and liquidity. We are currently a party to various other legal proceedings, in addition to those noted above,
and may become involved from time to time in other legal proceedings in the future. While we
currently believe that the ultimate outcome of these other proceedings, individually and in the
aggregate, will not have a material adverse effect on our financial position or overall results of
operations, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur in
any of our legal proceedings, there exists the possibility of a material adverse impact on our
results of operations for the period in which the ruling occurs. The estimate of the potential
impact on our financial position and overall results of operations for any of the above legal
proceedings could change in the future. 
 ITEM 6. EXHIBITS ExhibitNumber
    
    Exhibit Description31.1
    
    Certification of the Chief Executive Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of the Chief Executive Officer Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of the Chief Financial Officer Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
 48




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: May 9, 2005
    TERAYON COMMUNICATION SYSTEMS, INC.By /s/ Mark A. RichmanMark A. RichmanChief Financial Officer 49




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INDEX TO EXHIBITS ExhibitNumber
    
    Exhibit Description31.1
    
    Certification of the Chief Executive Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of the Chief Executive Officer Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of the Chief Financial Officer Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.